What is the impact of the ongoing tensions in the Middle East heating up? The potential escalation of conflict between Iran and Israel could have a significant impact on global oil prices, leading to broader economic effects such as high inflation. In this scenario, if oil prices rise due to geopolitical tensions or supply disruptions in major oil-producing regions, it could contribute to inflationary pressures. This would make it difficult for inflation to return to central bank target levels, such as the Federal Reserve in the United States, which targets long-term inflation at 2 percent year-on-year (yoy) within a two-year period. The United States has been battling inflation by raising its policy rate sharply to the current 5.5 percent level. With a new war potentially erupting in the Middle East, there is a high probability that inflation may stay high due to the spike of oil prices.

When inflation remains high, central banks typically respond by maintaining high interest rates to cool down the overheating economy and control inflation. Thus, rising oil prices could indirectly cause the Fed to maintain higher interest rates for a longer period than previously anticipated. The consequences are slowing economic activity, affecting everything from consumer spending to business investment. Additionally, this situation could also strengthen the value of the US dollar. When the Fed raises interest rates or maintains them at higher for longer, investment in dollar-denominated assets becomes more attractive because they offer higher returns. This tends to attract more foreign capital into the US money market, increasing demand for the dollar and ultimately strengthening the currency. A stronger dollar can further impact the global economy, especially in developing countries with dollar-denominated debt and economies heavily dependent on imports.

The ongoing war tensions will impact the US economy. When oil prices rise sharply, it can cause higher energy inflation. US inflation in March was recorded at 3.5 percent yoy, still above the Fed's expectation of 3.4 percent and far from the Fed's long-term target of 2 percent yoy, with energy inflation still rising by 1.1 percent yoy in March. If oil prices continue to increase, the cost of producing and shipping goods and services that rely on oil also increases, with a domino effect on the economy passed on to consumers in the form of higher goods prices. This is a critical consideration for the Fed, as they previously were expected to make three rate cuts this year. The recent survey showed expectations of US rate cuts shifted toward the end of the year, with the market expecting smaller rate cuts.

Thus, when we observe this situation, which could lead to a high Federal Funds Rate (FFR) for a long period, it will also have a significant impact on developing countries' economies, especially Indonesia’s. Higher US interest rates attract investors who are seeking better returns on dollar-denominated assets, such as US government bonds. This makes investing in emerging-market economies less appealing, leading to greater potential for foreign capital outflow, causing depreciation of the rupiah. This is reflected in the recent outflows in the stock market amounting to Rp 15.1 trillion month-to-date (mtd) and the bond market amounting to Rp 11.1 trillion mtd, leading to recent weakening of the rupiah.

On a positive note, recent trade data showed a widening trade surplus to Rp 4.4 billion in March, showing relatively strong fundamentals for the currency. Nonetheless, the export outlook is relatively subdued as Indonesia’s main trading partners – China, the US and the European Union – are mostly experiencing economic slowdowns. Hence, the government and the central bank should maintain synergy, implementing an appropriate policy mix supporting stability in financial markets that will cushion the economy from this external impact. Managing foreign exchange liquidity is imperative, by strengthening existing regulations, that is policies for the repatriation of export proceeds, and optimizing existing market instruments to attract more capital inflows.

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The writer is an economist at Bank Mandiri.