Oil Price and Monetary Policy: What are the Correlations for Banks?

2025-06-29

When oil prices surge or drop sharply, central banks are left with complicated decisions. These movements affect inflation, global trade, and household spending.

In 2025, the Iran and Israel conflict triggered some of the most unpredictable oil price swings in years, creating fresh uncertainty for economic forecasters.

This has placed extra pressure on central banks such as the Reserve Bank of Australia and the Bank of England, and the consequences flow directly to commercial banks and their lending decisions.

Oil Price Shocks Create Conflicting Pressures on Monetary Policy

The recent conflict between Iran and Israel caused sharp changes in the global oil market. At its peak, fears that Iran might close the Strait of Hormuz led oil prices to rise significantly.

This particular waterway is one of the most important shipping routes in the world, responsible for transporting around one-fifth of global oil. Any disruption raises immediate concerns for supply, which sends prices higher.

Markets reacted swiftly. Prices jumped as ceasefires broke, then fell again when it seemed both sides were backing away from escalation. The outcome was a volatile trading environment where oil fluctuated by several dollars per barrel within days.

For central banks, this volatility adds to an already complex environment. Higher oil prices increase petrol costs, pushing up inflation.

Yet at the same time, they reduce consumer spending, as households have less disposable income. Businesses, particularly those in transport and logistics, also face higher operating costs, which can slow investment and hiring.

This mix of inflationary pressure and economic drag creates a dilemma. If a central bank raises interest rates to combat inflation, it risks deepening a slowdown. If it cuts rates to support growth, it risks allowing inflation to rise unchecked.

The Reserve Bank of Australia, for example, typically assumes oil prices will stay at current levels in the short term and uses futures prices for medium-term forecasts.

But this assumption breaks down when geopolitical tensions cause wild swings. The bank must then decide whether to react immediately or wait for more stable conditions before changing rates.

Banks Feel the Consequences of Monetary Shifts and Price Volatility

Once a central bank moves interest rates, the effects pass quickly to the financial system. Commercial banks adjust their lending rates, reassess risks, and monitor changes in customer behaviour. But oil price volatility adds its complications to this chain.

For one, higher interest rates usually lead to lower loan demand. When borrowing becomes more expensive, households may delay home purchases and businesses may hold off on expansion.

This reduces lending volumes, which can impact bank profits. On the other hand, higher rates may improve margins on existing loans, especially those with variable rates.

Another issue for banks is inflation-linked uncertainty. If oil prices rise sharply and inflation follows, banks face greater risks on consumer and small business loans.

Petrol costs feed into many areas of household spending, from groceries to transport. This can stretch budgets and lead to missed repayments.

Banks also pay close attention to their exposure to sectors sensitive to energy prices. For example, logistics firms, airlines, and agriculture may face higher costs and thinner profit margins during oil price surges.

If these clients struggle, loan defaults may rise. Risk management teams must therefore update their models regularly to reflect new assumptions about fuel prices, input costs, and business sustainability.

In Australia, this has already played out with some banks reassessing their loan books following swings in energy and fuel markets. The same is happening in other countries where oil remains a key driver of inflation and interest rate expectations.

Even large banks with diversified portfolios are not immune, especially if inflation expectations become embedded and consumers lose confidence in price stability.

Inflation Trends and Interest Rate Timing in a Volatile Oil Market

One of the Reserve Bank’s primary inflation tools is the trimmed mean measure. This excludes large price movements, such as sudden spikes or drops in petrol.

Still, when oil prices move enough to dominate headlines, they influence public expectations. People may assume higher fuel costs will remain and adjust their behaviour. This may lead to demands for higher wages, reduced savings, or changes in consumption habits.

In May 2025, Australia’s monthly inflation figure dropped to 2.1% from 2.4% in April. This figure matches the lowest level since 2001, but central banks are cautious.

RBA Governor Michele Bullock reminded markets that the bank relies more on quarterly reports, which smooth out short-term swings.

Still, both headline and underlying inflation are now within the RBA’s target band of 2% to 3%. This opens the door for further rate cuts in the second half of 2025, possibly in August, depending on how global markets behave.

The decision is not easy. The threat of further oil disruptions remains, and the economic effects of the Iran and Israel conflict have not fully played out.

Globally, central banks are facing the same challenge. They must decide whether to act early and risk overcorrecting or wait and risk falling behind inflation.

For example, if the oil price rebound is temporary, central banks may choose to wait. But if supply remains tight and oil prices creep higher again, the pressure to act will return.

For banks, this means preparing for all scenarios. From adjusting lending criteria to revising forecasts, institutions must stay nimble.

Consumer confidence, inflation trends, and fuel costs all play into this complex system. As always, those who manage risk early tend to come out stronger.

Conclusion

In 2025, the Iran and Israel conflict exposed just how fragile global oil markets can be and how tightly they are linked to monetary policy.

For central banks, oil price volatility creates difficult trade-offs between inflation control and economic support. For banks, the effects are immediate, from changes in interest rates to shifts in lending behaviour and risk exposure.

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Frequently Asked Questions

1. Why do oil prices affect interest rates?

Because oil prices influence inflation and consumer spending. Central banks respond to these changes to keep inflation within target.

2. How does oil price volatility impact banks?

It affects loan demand, credit risk, and operational planning. Banks adjust their strategies based on inflation and consumer behaviour.

3. Was the oil price movement in 2025 caused by war?

Yes, recent swings were linked to the Iran and Israel conflict, which created fears over global oil supply and pushed prices up before stabilising.

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