Oil and inflation: why should we worry about ‘second-round effects’?

The conflict in the Middle East has resulted in a substantial increase in energy prices, alongside increases in other commodity prices. Headline inflation has already jumped in many countries. Central banks generally see this initial impact on energy price shocks as unavoidable. It is what comes next for inflation that they can do more about.

Our work suggests that so-called ‘second-round’ effects are much more likely if inflation expectations are high, labour markets are tight and following recent periods of high inflation. The UK, for example, is unfortunately flashing amber on these factors.

What central banks will be watching

After the initial direct impact on inflation through the fuel components of CPI, first, they will watch for the indirect impact of higher energy costs – higher electricity and transportation costs feeding through into the price of broader goods and services. Second, and usually even more closely, central banks will be watching for so-called ‘second-round’ effects. This refers to how higher energy costs feeds through into wage setting and inflation expectations, which can result in an even broader and more persistent impact on inflation.

We can trace what has happened in the past using core inflation and wages

One of the ways we can see how these second-round effects have played out in the past is by looking at how core inflation and wages behaved in the aftermath of energy shocks. Core inflation is often used to assess second-round effects as it strips out the direct effects of higher energy prices. Meanwhile, wage increases as a result of the energy shock would contribute to more persistent inflationary pressures and therefore need monitoring. 

Academic and central bank studies suggest second-round effects are influenced by the prevailing macroeconomic environment. In other words, how worried central banks should be is ‘state dependent’.

Academic and central bank studies suggest second-round effects are influenced by the prevailing macroeconomic environment. In other words, how worried central banks should be is ‘state dependent’. It matters how elevated inflation expectations already are, for example, or how tight the labour market is.

Using simple econometric modelling for the UK economy (see Technical Annex), we found that three factors look especially relevant. When these factors are elevated, the energy price shock has a stronger and more persistent impact on UK core inflation and wage growth.

1. Inflation expectations: Elevated inflation expectations may prompt workers to negotiate higher wages, accept higher prices, make firms less willing to accept margin hits, and encourage consumers to bring forward large purchases, intensifying inflationary pressures.
2. Labour market tightness: In tighter labour markets, workers tend to have more bargaining power over their wages, thereby increasing wage settlements.
3. Inflation awareness: Following periods of high inflation where there has been a significant change in the price level, consumers may be more attentive to renewed inflation, allowing shocks to transmit more quickly into wage and price setting dynamics. This reflects the 'spikeflation’ price level shocks described by our Head of Multi-Asset, Trevor Greetham.

Our findings are consistent with recent research from the Bank of England (April 2026 Monetary Policy Report) for the UK economy and IMF research, conducted in 2022, that found evidence of state-dependent pass through for the euro area.

Mapping our three factors over time helps explain past inflation shocks

Focusing on these state-dependent factors, we can immediately see why the oil shocks of the 1970s, for example, were so problematic.

During the oil shocks of the 1970s, surging oil prices were followed by persistently higher inflation (prompting central banks to tighten monetary policy). Our analysis shows that, at the time, inflation expectations were exceptionally elevated, and households, having recent experience of high inflation in the early 1970s, were likely particularly attentive to renewed inflation (Table 1).

In contrast, the 1990 oil shock and steady rise in oil prices from the early 2000s to 2008, resulted in far less inflation persistence (with many central banks eventually cutting rates as growth stalled). Our model would attribute that difference to relatively well-anchored inflation expectations, softer labour markets and lower household awareness of inflation, reflecting the prior period of relative price stability (Table 1).

Table 1: Scorecard: state dependent factors for second-round inflation effects

Source: LSEG Datastream; Bank of England; RLAM analysis. Colour scale reflects relative score compared to the historical average. Inflation expectations are measured using consumer survey data. For the US, the Uni. Of Michigan survey is used. For the UK, longer term estimates are sourced from the Bank of England and Citi/YouGov survey (available since 2006). Labour market tightness is proxied using the ratio of job vacancies to unemployment. In the US, historical data is sourced from OECD help-wanted adverts prior to the introduction of the number of vacancies in the JOLTS series (available since 2001). Inflation awareness is primarily proxied by the five-year rolling standard deviation of headline inflation. The five-year change in the price level was also tested with broadly consistent results.   

Compared with 2022

Compared with 2022, the risk of second-round pass-through currently appears more contained, but elevated inflation expectations remain a key vulnerability, and the UK looks more at risk than the US.

Softer labour market conditions since the pandemic should limit the strength of second-round effects compared to 2022, when labour markets across the US, UK, and euro area were exceptionally tight as economies reopened after the pandemic. Since then, labour markets have gradually softened, with labour market tightness currently broadly around average levels on our metric in the US and UK.

However, elevated inflation expectations on some measures and the recent experience of high inflation still provide a moderate risk of second-round effects. In 2022, inflation expectations were already elevated, amplifying the energy shock from the Russia-Ukraine war. At present, inflation expectations appear to be less elevated in both the US and UK. However, recent weeks have seen a notable rise in some inflation expectations in the euro area and elsewhere; and in both the US and UK, some expectations measures are elevated above the historical average. Moreover, having recently experienced a high-inflation period, households may be more attentive to renewed price pressures, which could then translate into higher wage demands. Our proxy for inflation awareness remains relatively elevated in the US and UK.

having recently experienced a high-inflation period, households may be more attentive to renewed price pressures, which could then translate into higher wage demands

Forecast = some second-round effects and (somewhat) higher interest rates

For now, we expect softer post-pandemic labour markets to limit the strength of likely second-round effects. But, with inflation expectations and our measures of inflation attentiveness where they are, some modest second-round effects look likely – especially in the UK and euro area, with risks skewed to the upside.

From a central bank perspective, much will depend on both the duration of the shock and the extent of any second-round effects. Both the Bank of England (BoE) and European central Bank (ECB) have published scenario analyses, highlighting that, if higher energy prices prove persistent, some policy tightening could be warranted. Recent ECB communication has leaned in this direction, with policymakers starting to place a greater weight on scenarios beyond the baseline, consistent with tightening. The BoE’s own scenario analysis, including monetary policy paths implied by Taylor-style rules, similarly suggests a persistent inflation shock and second-round effects could warrant a tighter policy stance.

Accordingly, in the central case, we continue to pencil in one ‘insurance’ rate hike from the BoE and two from the ECB, aimed at trying to prevent the energy shock from feeding through significantly into wage and price setting dynamics. We are expecting the Fed to remain on hold in 2026, but with the risk of a rate hike rising the longer the conflict persists.

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Technical annex

Our analysis is informed by a state-dependent Phillips curve framework for the UK economy, estimated using a quarterly data sample stretching back to the 1970s. The framework captures core inflation dynamics through a standard set of macroeconomic drivers, including labour market conditions, economic slack, energy prices and supply chain pressures. Where necessary, historical series have been constructed using a combination of official national statistics and data from established international sources to ensure coherence across the long sample period.

The framework allows the pass-through from energy price shocks to core inflation to be conditional on prevailing macroeconomic conditions. This has been achieved through interactions with state-dependent variables (labour market tightness, inflation expectations and our inflation awareness variable) and energy price shocks. Regressions are estimated using Ordinary Least Squares (OLS). State-dependent variables are incorporated into the baseline specification individually to mitigate multicollinearity and avoid competing for channels of variance. Energy shocks are modelled asymmetrically, with only positive shocks interacting with the state-dependent variables. This reflects an asymmetry in the economic responses to energy shocks; positive shocks tend to result in upward adjustments to inflation expectations and wage demands, whereas downward adjustments tend to be less pronounced following negative energy shocks.

The empirical results point to three distinct inflation regimes over the sample, reflecting major institutional and policy changes in the UK. In particular, the post-1990s period of central bank independence and inflation targeting. This period exhibits materially different inflation dynamics from earlier decades. As such, our baseline modelling has been estimated using data from this period (post-1997), which provides the most relevant benchmark to the current inflationary regime.

The modelling suggests that energy price shocks, on average, do not generate persistent effects on core inflation. However, when the state-dependent variables are elevated above their historical averages, the pass through from energy price shocks to core inflation becomes economically and statistically significant. This suggests these variables are critical in the transmission of energy shocks through to core inflation and shaping inflation persistence.

To ensure robustness and to ensure we are picking up more than just indirect effects of energy shocks, we have conducted tests on our model by applying a range of lag structures for energy price pass-through, spanning from 1 to 6 lags (equivalent to up to 18 months). In addition, we have estimated a comparable model for wages, in which wage growth is a function of past wage growth, inflation, labour market conditions, inflation expectations and our pass-through variables interacted with inflation. Our modelling shows that pass through from higher inflation to wages typically occurs between 3 and 6 quarters following an inflation shock and is dependent on prevailing macroeconomic conditions, in particular labour market tightness, inflation expectations and inflation awareness.

As with any empirical modelling, the results should be interpreted with care, considering the uncertainties. Most notably. the sample period includes a relatively limited number of energy shocks, with the energy shock from 2022 having an outsized influence on the sample and overall model fit. Nevertheless, the key findings are consistent with the broader academic literature and recent analysis published by the Bank of England and other leading institutions.