A mourner holds a poster depicting Mojtaba Khamenei, right, the successor to his late father Ayatollah Ali Khamenei, left, as supreme leader, during a funeral procession for senior Iranian military officials and civilians killed during the U.S.-Israel campaign in Tehran on Wednesday.Vahid Salemi/The Associated Press
Kevin Yin is a contributing columnist for The Globe and Mail and an economics doctoral student at the University of California, Berkeley.
The Great Financial Crisis in 2008 and COVID-19 were challenging times to run a central bank. But these crises were still somewhat tractable since both episodes were still fundamentally macro-finance problems. The war in Iran is an entirely different beast. As international relations play an increasing role in determining economic fundamentals, it seems central bankers must now be foreign policy experts, too.
Consider what the tradeoffs were for Federal Reserve chair Ben Bernanke in the Great Financial Crisis. At the time, what was unclear was how to stimulate the economy when interest rates were already near zero, the efficacy of quantitative easing, and the exact source and solution to a breakdown in financial plumbing.
These questions do not have simple answers, yet all are, at least, in the wheelhouse of a macroeconomic analysis. Our now-better understanding of these phenomena helps provide an accurate sense of where the economy is going. But they are not sufficient for today’s circumstances.
Iran attacks commercial ships and oil facilities as U.S.-Israeli strikes intensify
The Iran oil shocks matter because they simultaneously drive up prices and stifle production – a nasty combination. Since energy is an input to almost all goods and service production, a higher cost of energy gets passed through to consumers in the form of higher prices, thus inflation. But because it also makes producing goods more expensive (and consumers won’t be happy to absorb the full price effect), companies have to reduce their output simultaneously. So, understanding the probabilities and durations of various oil-shock scenarios is paramount for monetary policy.
The Bank of Canada’s models may be able to tell us where it thinks inflation will go given a trajectory for the price of oil. But to know the price of oil in one month is to know whether shipping through the Strait of Hormuz will remain viable, whether Washington will escalate or pull back, whether more strategic reserves will be released and whether Gulf producers can offset lost supply.
In other words, the inflation forecast now runs straight through military strategy and Iranian political-economy, not to mention the ever-elusive objectives of U.S. President Donald Trump.
The correct path of interest rates thus demands a grasp of a number of intangibles. A sense of the new Supreme Leader Mojtaba Khamenei’s personality would be helpful for example. But unlike his father, Ayatollah Ali Khamenei, he has never held government office nor given speeches or interviews that might help us get inside his head.
Furthermore, it is unclear to what extent the younger Khamenei is an independent actor, or constrained by his benefactors in the Iranian Revolutionary Guard Corps, or IRGC, who pushed his leadership through.
Mojtaba Khamenei named Iran's Supreme Leader, hardliners take to streets to proclaim loyalty
All else held equal, more IRGC consolidation of power is probably worse for oil prices in the short-to-medium term, since the IRGC is what the director of Brookings Institution’s Foreign Policy Program called “radically anti-American.” Its incentives will be to prolong the war long enough to avoid humiliation and further solidify its grasp on civilian arms of government, which means continued pressure on the Strait of Hormuz and persistent attacks on U.S. allies in the Gulf. In fact, the IRGC has already threatened exactly this in retaliation for American and Israeli air strikes on Tuesday.
Yet, while wartime will tend to shift power to the militarized IRGC, other more moderate factions can point to the war as an outgrowth of the IRGC’s hard-line policies, which could shift the long run balance of power away from it down the line. The organization is already deeply unpopular with an Iranian public that very recently was in open revolt.
While relatively unlikely, scenarios where mass unrest leads to regime change still need to be weighed correctly, especially as they may influence long-term oil prices, thus inflation expectations and long-term bond yields.
This is by no means an exhaustive list of relevant factors. But the examples indicate a very different challenge from the one faced in 2008 or 2020. Then, the unknowns were largely about transmission mechanisms inside the economy and financial system; today, the unknowns begin outside.
It is only a slight exaggeration to say that, right now, central bankers may be better off reading a biography of Ayatollah Khamenei than knowing how to solve a dynamic stochastic general equilibrium model.
In a world that is increasingly at odds with itself, the boundary between macroeconomics and geopolitics has become muddied. When a supply shock is driven by regime incentives and the credibility of military threats, good monetary policy requires strong judgment on these issues. That is uncomfortable territory for monetary economists. But pretending it lies outside their remit would be worse.