Iran War Price Shock Fuels Inflation Fears, with EU and Japan Raising Rates and U.S. Long-Term Yields Surging

Accelerating inflation in Europe and Japan, with central banks stepping up monetary tightening
Easing U.S. price pressures, yet persistent turmoil in long-term Treasury yields
Continued U.S.–Iran military and diplomatic tensions, with economic prospects at stake

Inflation indicators across major economies are flashing warning signs. Disruptions to energy supply chains stemming from the Middle East war have intensified inflationary pressures worldwide. Major central banks, including the European Central Bank (ECB) and the Bank of Japan (BOJ), are consequently accelerating their tightening timetables. In the United States, recent inflation readings have softened more than expected, tempering expectations of a near-term rate increase. Nevertheless, a resilient economy, fiscal deficits and concerns over further oil price increases have kept long-term Treasury yields elevated, sustaining pressure on financial markets.

Mounting Inflationary Pressures in Europe

According to energy news outlet Oilprice.com on September 30 (all dates local), inflation has recently accelerated across major European economies, led by energy prices. In Spain, the European Union (EU) Harmonised Index of Consumer Prices (HICP) rose 5.0% year over year in September, up 0.4 percentage points from 4.6% in August. The domestic consumer price index (CPI), compiled by Spain’s National Statistics Institute (INE), also accelerated from 4.3% to 4.9% over the same period. Core CPI inflation, excluding energy and unprocessed food, rose more modestly, increasing 0.2 percentage points from 2.9% in August to 3.1% in September. By category, energy prices surged 21.6% from a year earlier, substantially lifting headline inflation, while unprocessed food prices increased 5.8%.

A similar pattern emerged in Italy. According to preliminary figures from the Italian National Institute of Statistics (ISTAT), Italy’s national consumer price index for the whole nation (NIC) rose 4.2% year over year in September, up 0.9 percentage points from 3.3% in August. Inflation in regulated energy prices accelerated from 18.6% to 25.9%, while inflation in unregulated energy prices increased from 17.0% to 22.2%. Overall energy prices rose 22.3%. By contrast, Italy’s core inflation rate edged up from 1.5% in August to 1.7% in September, while inflation excluding energy stood at just 2.0%.

Intensifying ECB Monetary Tightening

Against this backdrop, the ECB sees a risk that persistently high energy prices could transmit upward price pressures more broadly across the economy and is incorporating that risk into its monetary policy decisions. At its September 10 monetary policy meeting, the ECB raised its deposit rate by 0.25 percentage points, from 2.25% to 2.50%, and increased its main refinancing rate and marginal lending rate by the same margin, to 2.65% and 2.90%, respectively. Having held all three policy rates steady at its July meeting, the ECB resumed tightening after roughly two months.

The ECB cited the energy price shock arising from the Middle East conflict and the resulting inflation as the rationale for the increase. Its assessment is that the conflict continues to generate inflationary pressures and that eurozone inflation could remain significantly above its 2% target for a considerable period. The ECB projects average eurozone consumer price inflation of 3.0% this year, 2.5% in 2027 and 2.1% in 2028. It identified the intensity and duration of the energy price shock, along with the indirect effects of higher energy prices feeding through to other goods and services prices and wages, as key determinants of the future inflation path.

Accelerating Rate Increases in Japan

Monetary tightening in response to inflationary pressures is also evident in major economies outside Europe, with Japan a prominent example. The BOJ began monetary policy normalization in earnest in March 2024, when it ended its negative interest rate policy. It raised its policy rate to 0.25% in July that year, followed by increases of 0.25 percentage points in January and December last year. This June, it lifted the policy rate from 0.75% to 1.0%, and on September 18 raised it again, from 1.0% to 1.25%. The BOJ explained that rising producer prices, driven by higher crude oil prices, a weaker yen and expanding demand related to artificial intelligence (AI), had fed through to consumer prices. Businesses also continued to pass wage increases on to selling prices. In its assessment, these developments have increased the risk of underlying inflation exceeding 2%.

Japan’s recent consumer price inflation has fluctuated in the upper 1% range. According to Japan’s Ministry of Internal Affairs and Communications, nationwide CPI rose 1.9% year over year in August. CPI excluding fresh food, a key inflation measure monitored by the BOJ, increased 1.7%. Inflationary pressures are more pronounced in Tokyo, where price data are considered a leading indicator of nationwide inflation. Figures released on October 2 showed that CPI excluding fresh food in Tokyo’s 23 wards rose 2.7% year over year in September, accelerating sharply from 1.8% in August. Inflation excluding both fresh food and energy increased from 2.0% to 3.0% over the same period, while services inflation rose from 1.4% to 2.3%.

Table 1. Inflation and Monetary Policy Across Major Economies

Persistent Turmoil in U.S. Financial Markets

In the United States, August core personal consumption expenditures (PCE) inflation, closely watched by the Federal Reserve (Fed), softened unexpectedly. On September 30, the U.S. Department of Commerce reported that the August core PCE price index, excluding food and energy, rose 0.2% month over month and 3% year over year. Economists had forecast increases of 0.3% and 3.3%, respectively. With inflationary pressures falling short of expectations, markets scaled back expectations of further tightening. After the September 30 PCE release, CME FedWatch put the probability of a 0.25-percentage-point rate increase at the October Federal Open Market Committee (FOMC) meeting at roughly 35%–37%. Just a week earlier, that probability had hovered around 70%.

Pressure in the bond market, however, has yet to abate. The U.S. 10-year Treasury yield surged more than 80 basis points in the third quarter, recording its largest quarterly increase since 1994. On October 1, it climbed as high as 5.342% during trading, reaching its highest level since 2002, roughly 24 years ago. The unexpectedly resilient U.S. economy is one reason long-term Treasury yields remain elevated. Continued economic growth has reinforced expectations that the Fed could keep interest rates high for an extended period. Concerns that the Middle East conflict could reignite inflation, together with the U.S. government’s large fiscal deficits, are also exerting additional upward pressure on long-term yields.

Uncertain Prospects for an End to the War

As the war’s repercussions deepen turmoil in financial markets across major economies, military tensions between the United States and Iran show little sign of easing. In an interview with Time published on October 1, President Donald Trump was asked whether he would intensify bombing against Iran after the November 3 midterm elections and replied, “It’s possible.” Asked about his earlier statement at the United Nations (UN) General Assembly that he could annihilate Iran, he said, “We will, and we can,” adding, “I never think we can have peace as long as Iran exists.” Following Trump’s remarks, Bloomberg reported the same day, citing U.S. officials, that “the Pentagon could deploy an additional aircraft carrier and approximately 10,000 Navy and Marine Corps personnel to the Persian Gulf.” The deployment would broaden the options available to U.S. military commanders should Trump decide to expand the offensive.

The rift between the two sides was also evident in diplomatic negotiations. According to an October 1 report by U.S. news outlet Axios, U.S. Secretary of State Marco Rubio demanded on September 28 that the Iranian delegation, including Foreign Minister Abbas Araghchi, immediately leave the United States while its members were in New York for the UN General Assembly. The delegation reportedly headed to the airport a few hours later and departed New York in the early hours of September 29. Axios said the United States had demanded their departure after negotiations failed to deliver the progress Washington had expected, describing it as a highly unusual diplomatic move even if the delegation had originally planned to return home around that time. Commenting on these developments, one market expert said, “As long as the conflict between the United States and Iran remains unresolved, the future interest rate paths of major economies will depend on how the war’s repercussions affect financial markets and the real economy,” adding, “Central banks will assess how far higher oil prices feed through to inflation and inflation expectations, and how effectively financial markets absorb the shock, before deciding whether to raise rates further.”