The market’s inflation fears are understandable, but the more important question is how the economy responds.
The debate has shifted quickly. Earlier this year investors were focused on the timing of future interest rate cuts. Today they are debating whether higher energy prices warrant a more restrictive monetary policy, and if so by how much.
The inflationary consequences were immediate. Oil rose from around $US72.50 per barrel following US attacks on Iran in late February to more than $US160 within two weeks. The conflict extended disruption into the Red Sea, leaving oil around $US100 per barrel.
As markets shifted from viewing the shock as temporary to potentially persistent, expectations for US Federal Reserve policy swung from 75 basis points of cuts to 110 basis points of tightening, while US 10-year Treasury yields climbed roughly 120 basis points.
Australian bond yields have risen 80 basis points to near 5.4 per cent, with expected cash rates moving above 5 per cent.
The Reserve Bank of Australia has highlighted higher energy costs as a key driver of recent inflation pressures. Yet, there is a risk that investors are focusing on the immediate inflation shock while overlooking the adaptive response it is creating.