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The world’s top central banks are expected to hold off raising interest rates this week, as officials gamble they can take longer to assess whether the energy shock from the Iran war risks a prolonged period of high inflation.
The US Federal Reserve, European Central Bank, Bank of Japan and Bank of England will decide on official borrowing costs under the shadow of the conflict, which has sparked the second big global energy shock in five years.
Rate-setters are having to consider the scale of the threat that geopolitics and the unpredictable dynamics of commodities markets pose to their inflation targets.
Hanging over this week’s meetings are memories of the last big inflationary upsurge in 2021 and 2022, when many central banks were accused of acting too slowly to quell price growth.
Despite the episode highlighting the perils for central banks of being flat-footed, Tomasz Wieladek, chief European macro strategist at T Rowe Price, said that a “wait and see” approach was the right one “given the uncertainties surrounding the situation in the Gulf, as well as the lack of clarity on how the energy shock will transmit into growth and inflation”.
In a sign of the challenge facing rate-setters in forecasting inflation, Sebastian Barrack, head of commodities at hedge fund Citadel, told a FT conference in Switzerland last week that US President Donald Trump’s social media posts during the war had transformed how oil markets behaved.
Traders are often left struggling to adjust to the volatility sparked by his frequent messages and responses from the Iranian regime.
Instead of focusing on one central forecast, rate-setters are putting greater emphasis on scenarios that take into account a range of possible outcomes in the Middle East conflict.
“It is challenging for a central banker who is accustomed to thinking about marginal pricing and the evolution of the labour market,” said Jens Larsen, a former BoE official who is now at Eurasia Group.
Financial markets are pricing in two interest rate increases by the ECB this year from the current level of 2 per cent.
But last week ECB chief economist Philip Lane made it clear that his institution was wary of rushing to judgment. “Until we know more about how long this war is going to last, it’s really hard to know whether this is going to prove to be a temporary phase or a much bigger shock to the European economy,” he said during a panel discussion in Frankfurt.
Morgan Stanley economist Jens Eisenschmidt said that the moment when the ECB could “first properly assess whether it needs to act will come no earlier than June, possibly even later”.
Compared with most other western central banks, including the Fed and the BoE, the ECB was in “a better position”, said Katharine Neiss, chief European economist for PGIM Fixed Income. “They’re actually the only central bank that got inflation back down to 2 per cent.”
US rate-setters will vote on Wednesday, with a hold within the 3.5-3.75 per cent benchmark range widely seen as a near-certainty. The Fed has parked any prospect of interest rate cuts until officials have a clearer sense of whether the Iran war will impede their ability to hit their 2 per cent inflation goal, or damage a US jobs market that was already weakening. Annual US personal consumption expenditure (PCE) inflation stood at 2.8 per cent in February.
But some leading officials are beginning to sound the alarm on inflation risks. Fed governor Chris Waller this month warned that a series of price shocks — not only emanating from the war, but from Trump’s trade policies — threatened to erode the American public’s trust in the Fed to control US price pressures.
The longer energy prices remained high, Waller said, the greater the chances were of higher inflation becoming “embedded” across the US economy — and that households and businesses would begin to price in permanently stronger price pressures.
“We’re entering another supply shock of indeterminate length and inflation in the US is still well above target,” said Joe Lavorgna, chief economist for the Americas at Sumitomo Mitsui Banking Corporation and former economic counsellor to US Treasury secretary Scott Bessent.
While investors had until recently been predicting that the BoJ would this week raise its key rate from around 0.75 per cent, the market now attaches a very low chance to that happening.
Uncertainties created by the conflict in Iran have combined with specific fears around Japan’s vulnerability as a heavy importer of energy and raw materials critical to its manufacturing industries.
Recent speeches by the BoJ’s governor, Kazuo Ueda, have not included any remarks that suggest an April rate increase. Officials have also let it be known that the central bank is no longer in the business of trying to catch the market off guard.
UBS economist Go Kurihara said Tuesday’s decision by the BoJ was likely to be accompanied by a sharp increase in the central bank’s inflation forecasts and a downward revision in the economic outlook.
Similarly, the BoE in March appeared to raise the prospect of a near-term rate increase from 3.75 per cent, but traders are putting extremely low odds on such a move following signals from governor Andrew Bailey that investors were getting ahead of themselves.
“They [rate-setters] want to know if we are heading into a situation like 2022, when inflation rose a lot more than expected, and they simply can’t assess this on the basis of a single month’s data,” said Wieladek.
Data visualisation by Ian Hodgson and Alan Smith