A widening gap between global economies

Source: Nida Al Watan

The Institute of International Finance (IIF) has issued a report on global economic trends following the US–Iran war and the oil price shock, updating its earlier growth forecasts made before the outbreak of the conflict. The revisions show a significant downgrade in expected growth, which has fallen by at least 30% compared to previous estimates.

In this capital flows report, the IIF notes a substantial deterioration in global expectations as the Middle East shock moves beyond the initial oil repricing phase into broader mechanisms affecting production, trade, financing, and policy adjustments. The global economy is now heading toward growth of around 2% in 2026, compared to 3.1% in the baseline from its December capital flows report, with its working baseline now closer to 2.8%, and a much worse scenario if disruptions persist. Oil prices surged sharply in the early phase of the shock and remain volatile. The central issue for the global economy is no longer just price increases, but ongoing disruptions across energy, shipping, fertilizers, refined products, and intermediate inputs.

The global economy entered this period with less capacity to absorb another shock. Growth has already become increasingly uneven across sectors and regions. US economic activity continues to outperform, supported by resilient consumption, AI-related capital spending, and relatively strong household balance sheets, while Europe remains weak and China continues to struggle with a prolonged real estate adjustment and soft domestic demand. As a result, the energy shock is hitting a world already characterized by divergence rather than synchronized expansion. That divergence is now intensifying.

Higher energy prices are pushing up fertilizer costs, transport expenses, petrochemicals, and a wide range of intermediate goods, raising costs across both agriculture and manufacturing simultaneously. Shipping disruptions, rerouting, longer delivery times, and inventory rebuilding are increasing working capital needs and reducing supply reliability. These pressures may persist even as the conflict eases, as higher insurance costs and rerouting behavior tend to respond to perceived risk rather than actual incidents alone. The Red Sea experience suggests that a decline in incident rates does not automatically translate into a quick recovery in shipping flows.

Countries and companies with stronger buffers are better able to absorb higher energy costs, rebuild inventories, and maintain access to external financing. Economies with weaker external positions, limited fiscal space, or higher dependence on imported energy face more difficult adjustments. The next phase will therefore be defined by increasing divergence across countries and sectors rather than a uniform global slowdown.

Monetary policy implications

Central banks are facing slower growth alongside renewed price pressures stemming from energy, transport, food supply chains, exchange rates, and supply reliability. As a result, monetary policy is less focused on traditional demand management and more on operating in a constrained environment.

For the Federal Reserve, caution remains the dominant stance. Slower activity and tighter financial conditions could eventually justify easing, but energy-driven inflation pressures and supply-side uncertainty reduce the urgency to act quickly. The likely outcome is an extended “wait-and-see” phase, with the Fed responding gradually to incoming data to assess whether the shock will fade or become more persistent. Markets therefore continue to oscillate between growth concerns and inflation concerns.

The European Central Bank faces a more difficult adjustment, as the euro area remains more exposed to imported energy shocks than the United States. Even moderate persistence in oil and gas prices can directly affect inflation expectations, wage formation, and industrial costs across Europe. Weak activity is likely to coexist with more persistent inflationary pressures, increasing the probability that the ECB maintains a tightening bias despite fragile growth conditions. The ECB is now expected to raise interest rates twice in 2026, as imported inflation becomes harder to ignore and spillover risks rise.

The Bank of Japan is likely to continue normalizing policy at a slower pace than previously expected, reflecting the tension between imported inflation and weak external demand.

The United States retains several internal stabilizers that soften the initial phase of the shock, including domestic energy production, continued AI-driven investment, relatively resilient consumption, and deeper capital markets. This does not imply immunity. The main risks to the US economy increasingly lie in second-round effects: tighter financial conditions, weaker external demand, supply chain disruptions, and declining confidence if the shock persists.

Europe faces direct energy pressure, while Japan remains vulnerable due to imported energy costs and sensitivity to external demand.

Emerging markets

Emerging markets are diverging sharply rather than moving through a unified crisis dynamic. Latin America remains relatively well insulated, with high yields, commodity exposure, and strong external balances. The Brazilian real continues to benefit from high real interest rates and a stronger external environment, while the Mexican peso remains supported by stable investment inflows and sound macroeconomic fundamentals.

The strength of the Chinese yuan should be seen as relative insulation rather than full protection. The currency has risen to nearly a three-year high, above 6.8, supported by lower relative energy exposure, demand for green chemicals and coal, and moderate inflation supporting nominal profits. However, higher energy costs and weak external demand continue to constrain the broader balance of payments.

Interest rate markets are currently in an unstable transition phase between an inflation shock and a growth shock. The initial reaction to the energy shock pushed up short-term bond yields, as markets questioned how quickly central banks could ease renewed price pressures.

If energy flows gradually normalize, part of the inflation premium could fade. But if disruptions persist, markets will increasingly price in weaker growth, tighter financial conditions, and slower investment. The timing of this shift is becoming critical for yield curves, currencies, and capital flows.