International Conflict Complicates Australian Economic and Interest Rate Outlook

Key points:

• Recent economic and inflation data, along with the RBA’s revised February forecasts, strengthen the case for a quick follow-up interest rate rise in March.
• Developments in the Middle East and oil price movements complicate the picture. While higher oil prices add pressure on inflation, they will also slow growth.
• Much ultimately will depend on the extent to which energy-producing infrastructure is impacted. The current sharp rise in prices reflects the closure of the Strait of Hormuz, through which 20% of global oil and LNG production flows daily. If the conflict proves short-lived this should easily re-open, whereas energy infrastructure can take longer to rebuild. The large proportion of global oil demand flowing through this waterway means large oil price rises could continue.
• Meanwhile, although the recent market concerns about AI have been temporarily diverted, the big AI questions continue in the background: will a lot more jobs be destroyed than created in the long term; could there be significant capacity constraints in the near term associated with the massive global data centre rollout; and which business models are most vulnerable to disruption?

Persistent inflation and low unemployment make a very strong case for a further interest rate rise in the near term

The RBA Board increased the official cash rate by 0.25% in February as above-target inflation in Q3 and Q4 and continuing low unemployment meant the RBA could not forecast the return of inflation to the 2.5% midpoint of the target without higher interest rates. Furthermore, the February forecast assumed at least one further interest rate rise would be necessary to bring inflation back toward target. Even then, the return to target is projected to be relatively slow, with inflation not dropping below 3% until mid-2027 and not returning to near 2.5% until mid-2028. This raises the risk that more than one further interest rate rise may be required given inflation has already been well above target for an extended period and high inflation tends to impact more on the poorer members of society.

Data released since the February meeting makes a strong case for a quick follow up interest rate increase with inflation remaining elevated - and very close to 3.5% rather than the 2.5% target – the unemployment rate remaining at a pleasingly very low 4.1% in January and Q4 GDP of 0.8% q/q and 2.6% y/y both running at rates above the RBA’s recently revised assessment of the economy’s growth capacity.

Current International conflicts complicate things

The above economic developments largely pre-date the recent developments in the Middle East. As seen during the 1990 Gulf War, oil prices have risen very sharply (up over 50% since before the Middle East developments, including a temporary $20pb or nearly 25% rise on Monday the 9^th March 2026), share prices have weakened (on economic growth concerns related to higher oil prices), and longer-dated bond yields have risen (on inflationary concerns).

Technically, this is a supply shock for the economy. For most firms, the cost of doing business rises and less output is produced for any given level of price. At the same time, demand may weaken if oil prices are sustained at higher levels (reducing real incomes), business confidence falls, or central banks raise interest rates to combat inflationary pressures.

While each of these scenarios depends critically not only on the extent to which oil prices rise and how long prices remain elevated, it’s important to note that the price rises from the closure of the Strait of Hormuz, through which 20% of the world’s oil and LNG are shipped each day, are likely to be larger but also more temporary than the rises that might occur from significant damage to energy-producing infrastructure. The latter can cause more persistence in elevated prices.

AI still looms large in the background

The above conflict has diverted the markets’ attention away from AI, something that has been a key focus in recent weeks and also provided a fair share of volatility. The issues related to AI, however, do not simply disappear because there is military action abroad. There are three key issues to be considered:

1. In the medium to longer-term, does AI destroy substantially more jobs than it creates? If that is the case, it is likely there will be a downward bias to interest rates in the medium-term, with increased taxation on the wealthy and businesses benefiting from AI.
2. Relatedly, which business models will be most impacted by AI? Software as a service companies’ share prices have been very significantly impacted over the past six weeks.
3. In the short term, there is also the question of whether the scale of the data centre rollout could create supply chain difficulties and add to inflationary pressures at a time when most central banks are still battling above-target inflation. There are already reports of supply chain unreliability in semi-conductors, while demand for selected commodities (e.g. copper), electricity and water is likely to rise materially. This will pressure input costs and will also likely create something of a mini boom in parts of mining, already an under-appreciated area of support for Australian economic growth.

What it means for your business  

The Megatrends we have written about in the past (AI, Ageing, Geopolitics, Climate Change and Inequality), continue to significantly impact businesses and the economy. This month, geopolitics has come to the fore in the form of military action in the Middle East, though the equally uncertain shorter- and longer-term impacts of AI continue in the background.

To cope with the uncertain times in which we live, businesses should try and carry some extra cash reserves or consider a line of credit for unforeseen developments. Many suppliers will likely implement freight surcharges, which should only be temporarily passed on to consumers as any more sustained rise in inflation may result in still higher interest rates from the RBA.

We can’t be certain how long the current conflict in the Middle East will last, but the prospects are reasonable for a quick oil price unwind when hostilities cease provided oil-producing infrastructure is not significantly affected. As always, re-examining what can be done to boost productivity at times such as these, is a useful exercise that should produce some increased protection for your business from external events.

 

Author: Ivan Colhoun  Consulting Economist for Bank of Sydney Bachelor of Economics (Hons) Ivan is a highly experienced chief economist and keynote speaker on the Australian economy and financial markets. His career has included leadership roles within financial and professional service organisations, as well as the Reserve Bank of Australia.