Markets are forward-looking. Markets often rally before the economy has actually improved. While inflation may still be elevated and central banks may still be reluctant to cut interest rates, stocks can rally simply because traders begin to believe that the worst-case scenario is becoming less likely. In the current context, oil prices are central to this because energy is one of the main channels through which the geopolitical shock is affecting inflation, economic growth and monetary policy. Oil is an input cost for businesses, a major component of household expenditure and an important driver of short-term inflation. Therefore, a sustained increase in oil prices can affect the most important side of the central bank's mandate: price stability. If a geopolitical crisis threatens oil production or disrupts a major shipping route, traders begin to price in the possibility of reduced supply, pushing crude prices higher. Even before the disruption fully affects physical supply, the increase in energy prices can influence inflation expectations and financial markets.The first effect is on inflation. Higher oil prices directly increase the cost of fuel and other energy products. They can also indirectly raise the cost of transporting goods, manufacturing products and providing services. If businesses pass these higher costs on to consumers, the initial energy shock can spread into broader inflation.The second effect is on economic growth. Households have less money available for discretionary spending after paying more for fuel and energy, while businesses face higher operating costs and potentially lower profit margins. If the shock persists, consumption and investment can weaken.This creates a difficult environment for central banks as they may face rising inflation and slowing economic growth, making it harder to justify monetary easing even as the economy comes under pressure.The key point is that an oil shock can be simultaneously inflationary and damaging to growth. This is generally unfavourable for equity markets because it can put upward pressure on interest rates while weakening the earnings outlook.When oil prices decline, some of this pressure can reverse. Traders reduce their inflation forecasts, lower their expectations for future policy rates and become more willing to pay higher valuations for equities.The lesson is that traders focus on whether the decline also changes the expected path of inflation and monetary policy. If tomorrow the geopolitical crisis gets resolved, for example, traders would immediately start to reprice the negative growth expectations and buy equities. That's because traders would expect inflation to fall alongside oil prices and the central bank to adopt a less hawkish stance. Falling oil prices can trigger an equity rebound because they reduce the perceived risk of a damaging combination of persistent inflation, restrictive monetary policy and weaker economic growth. But the impact depends on the reason for falling oil prices. If it's just temporary, then the future outlook doesn't change much and the rebound would eventually fade. If it's durable, it changes drastically the previous expectations, making a rebound solid and long-lasting. This article was written by Giuseppe Dellamotta at investinglive.com.