The last time the world faced a sudden surge in inflationary pressures from a severe supply shock and spiking energy prices, in 2021-22, major central banks responded in unison. That’s unlikely to happen this time around.
Five years ago, pandemic-related supply disruptions kicked off a unified - if belated - interest rate-hiking cycle among the world’s biggest central banks that sped up in the face of sky-rocketing energy prices triggered by Russia’s invasion of Ukraine in February, 2022.
The Norges Bank raised rates in September 2021, and by the time the European Central Bank hiked in July 2022, every G10 central bank except for the Bank of Japan was on board. And all of them lifted policy rates by 400-525 basis points.
The current war in the Middle East has caused the biggest monthly jump in Brent crude oil prices on record and is disrupting other supply chains too, threatening to boost global inflation. That is shaking up central bank projections yet again.
Policymakers are wary of being too late to respond to that inflationary threat, as many believe they were in 2021-22, and rates markets are shifting accordingly.
Not only have the two U.S. rate cuts priced in for this year disappeared from the futures curve, the ECB is now expected to hike perhaps three times, and the reversal in the expected path for UK rates has been even more astonishing.
Should we expect central banks to continue moving in lockstep as they did five years ago?
Not if the supply crunch deepens.
Rates markets, like all others, are working under the assumption that the Middle East conflict will end soon and that the Strait of Hormuz will re-open, allowing global supplies of oil, liquefied natural gas, fertilizer, and other energy products to begin flowing again.
This benign, base-case scenario assumes energy prices will drift lower after the war ends but remain elevated on an annual average basis, while global growth will hold up, justifying a relatively hawkish stance from most central banks.
But what if the war doesn’t end soon, energy prices don’t come down, or they even continue rising? What would central banks do then?
Economists at UBS estimate the potential effects from three Middle East conflict scenarios: a rapid resolution; a two-month disruption to the Strait of Hormuz, with oil peaking near US$130 a barrel; and an “extended disruption scenario” involving further damage to energy infrastructure and oil rising to US$150.
In that latter scenario that triggers recession, the Federal Reserve could cut U.S. rates all the way to the zero lower bound next year, and the Swiss National Bank would deploy negative interest rates again, they reckon.
The Bank of England, on the other hand, might only reverse the two or three rate hikes currently priced in for this year, while the ECB might not cut rates at all.
“The 2022 playbook does not apply equally across central banks, and we expect significant policy divergence at higher energy price levels,” UBS economists wrote, citing the “considerable dispersion” across economies.
Today, the U.S. labor market is stagnant, while average monthly job growth in 2022 was over 600,000. Compared with five years ago, current price pressures are reasonably benign, tariffs notwithstanding, and policy is much tighter. Also, will the incoming Fed chair be in a rush to hike rates into a weakening economy?
In contrast, the euro zone labor market is fairly tight today, growth is close to trend, and monetary policy is closer to neutral than U.S. policy is. Moreover, the ECB’s sole mandate is its 2-per-cent inflation target, so it is probably more naturally inclined to tighten than loosen policy.
So you can see a scenario where the big central banks potentially diverge, which could widen interest rate and bond yield differentials, accelerate exchange rate swings, and increase macro volatility. As if there isn’t enough uncertainty hanging over markets as it is.
Fed Chair Jerome Powell said 15 times at his post-meeting press conference in March that no one – including him and his colleagues – knows what the economic effects of the war will be. So it’s impossible to say right now what the appropriate policy response is.
What we can assume is that the deeper the disruption, the likelier it is that the big central banks will go their own way.