Central banks set to end year cautiously amid Middle East risks

Last week, the Federal Reserve, the European Central Bank and the Bank of Japan all left interest rates unchanged, as markets had anticipated. December looks set to follow a similar pattern: unless the situation in the Middle East improves, a rate increase remains the most likely outcome, except possibly in Japan, where high levels of debt restrict the scope for policy tightening.

So why doesn’t action happen now?

Beginning with the Fed, the argument for raising rates is already strong. Inflation continues to run hot, standing at 3.6% year over year in September. Meanwhile, the US economy is growing robustly — GDP rose at a 3.4% annualised pace in the third quarter of 2026, compared with 2.2% in the second — and both consumer spending and investment remain solid.

As a result, two members of the Federal Open Market Committee voted for a 25-basis-point increase.

The majority of the committee, however, are holding off, apparently cautious about how events in the Middle East will develop — whether peace negotiations advance or conflict reignites. Oil prices continue to be a critical factor: any fresh disruption to supply lines or energy facilities could drive crude higher, stoking inflation and making it harder to avoid a rate hike.

Even though the US administration has approved a draft agreement with Iran that includes mutual steps on its nuclear programme and frozen assets, a clear resolution remains elusive.

Turning to the ECB, the situation differs from the US. Consumption is weak, there is no boom in AI-related investment, and inflation is mainly being pushed by energy costs. For that reason, it too opted to wait and assess how the Middle Eastern situation evolves.

Lastly, the Bank of Japan highlighted new inflationary risks from energy costs, a declining yen, wage increases, and global demand for semiconductors and other AI-linked goods, raising the likelihood of further rate rises. A sustained depreciation of the yen could exacerbate imported inflation, making monetary tightening more probable. The potential risk is that this could disrupt global markets, fuelling renewed volatility in currencies as yen carry trades unwind, and also affecting bond markets.

What does this mean going forward?

If the conflict intensifies from occasional exchanges of fire into full-blown military operations, with renewed attacks on oil refineries and efforts to block the Strait of Hormuz and Bab el-Mandeb, inflation could receive another jolt, leaving central banks with little option but to tighten.

On the other hand, a reduction in tensions would give central banks more leeway to keep rates unchanged or even start reducing them. At present, however, markets are still preparing for tighter monetary policy, which is weighing on stocks, bonds and even gold.