RBNZ’s Conway Warns Middle East Conflict Could Force More Rate Hikes

Reserve Bank of New Zealand Chief Economist Paul Conway has signalled that renewed fighting in the Middle East poses upside risks to inflation, potentially forcing the central bank to deliver more rate hikes after last week’s first tightening move in three years.

The New Zealand dollar strengthened following Conway’s comments, with the kiwi climbing 0.7 percent against the US dollar to trade at 0.6145 as markets repriced the interest rate outlook. New Zealand government bond yields surged, with the two-year rate jumping 12 basis points to 3.18 percent as traders abandoned hopes for a quick return to easing.

The benchmark NZX 50 Index fell 0.9 percent as higher rate expectations weighed on growth-sensitive sectors, with property and consumer discretionary stocks leading declines.

The Latest

The RBNZ raised its Official Cash Rate by 25 basis points to 2.50 percent on 9 July 2026, marking the first increase since 2023 after a lengthy easing cycle that had taken the OCR down to 2.25 percent. The July decision came alongside a revised inflation forecast that cut the third-quarter CPI outlook to 3.3 percent year-on-year from a previous 4.3 percent projection, largely reflecting falling fuel prices that had provided temporary relief.

However, oil traders have since reversed course on fresh Middle East conflict, undermining the assumption of smooth disinflation that underpinned the bank’s more benign near-term inflation track. Conway’s latest remarks suggest the central bank is prepared to respond aggressively if energy-driven price pressures prove persistent rather than transitory.

Market pricing now reflects expectations for the OCR to reach 3.0 percent by December 2026, implying two additional 25 basis point hikes before year-end. Traders have also priced in another increase in the first quarter of 2027, pushing terminal rate expectations above 3 percent for the first time since the bank began its 2024-2025 easing campaign.

Central Bank Stance

Conway emphasised that while spare capacity in the New Zealand economy should theoretically limit firms’ pricing power, the central bank will act if businesses continue passing higher costs through to consumers. The comments represent a more explicit conditional hawkish bias than the July monetary policy statement, which had stressed the bank would “look through” first-round energy price effects but remain alert to second-round wage and expectations channels.

The RBNZ’s evolving narrative reflects a significant shift from earlier in 2026. In April, the bank kept rates on hold at 2.25 percent while noting that Middle East events had “materially altered the outlook and balance of risks” for inflation. By May, the central bank’s base case still treated the oil shock as temporary, projecting CPI inflation peaking around the mid-4 percent range before returning to target as energy prices normalised.

The July decision appeared to validate that optimistic scenario, with falling oil prices supporting a lower inflation forecast and a modest 25 basis point hike. Yet within days, renewed fighting drove crude prices sharply higher, forcing Conway to acknowledge that the September quarter forecast now faces meaningful upside risk.

Cross-Border Implications

Conway’s warning carries significance beyond New Zealand, particularly for the Reserve Bank of Australia, which faces similar external energy shocks but with different domestic inflation dynamics centred on housing and wages. The RBNZ’s willingness to resume tightening in response to supply-driven inflation risks provides a template for how inflation-targeting central banks may respond when disinflation stalls.

Markets have begun repricing RBA expectations in response to the RBNZ’s stance, with Australian front-end yields rising and the probability of near-term rate cuts declining. The Australian dollar has also strengthened against low-yielding currencies as traders factor in a longer period of elevated policy rates across the Antipodean economies.

Outlook and Analysis

The key question for markets is whether the current oil spike proves temporary or marks the beginning of a sustained period of elevated energy prices that feeds into broader inflation. If crude prices remain elevated and New Zealand businesses continue raising prices, the RBNZ may need to deliver the full hiking cycle now priced by markets, potentially taking the OCR above 3 percent for an extended period.

However, Conway’s emphasis on spare capacity suggests the central bank still believes the economy’s weak growth backdrop should eventually constrain inflation, even if monetary policy needs to “work harder” in the near term. The unemployment rate has risen to 5.2 percent from a low of 3.2 percent in 2022, and retail spending remains subdued despite earlier rate cuts.

For forex traders, a higher OCR trajectory supports the New Zealand dollar, particularly against currencies whose central banks are further along in easing cycles. Yet the broader risk sentiment implications are more ambiguous, as a resumption of tightening in a small open economy like New Zealand may signal that global disinflation has stalled, potentially forcing other central banks to reconsider their policy paths.