The central bank bonanza returns to town this week and there will be a number of big names on the agenda. The BOJ, BOC, Fed, BOE and ECB will move but all are expected to keep interest rates unchanged.
The hot topic is the Middle East war and we are now officially nine weeks in. And yet despite all the talk of progress, the Strait of Hormuz remains closed and physical oil prices remain high. Sure, the price we see on our screens may be less concerning, but the prices exchanged for physical barrels and what consumers are paying at the pumps are completely different.
And it is much the latter that is going to be a major issue for central banks. Especially if the status quo persists for a long time and higher energy prices have a greater impact on other parts of the economy.
To keep things simple, central banks are now considering raising interest rates to counter rising inflationary pressure from surging energy prices. Some were already considering taking more active steps, but have now gradually backed away from this, although this has already changed market expectations.
That’s what I don’t like about it. Monetary policy is inadequate to deal with supply shocks and/or negative demand shocks. And that’s exactly what we’re seeing now as oil and gas prices skyrocket. The factors that drive inflation are driven by cost-push factors, which central banks abhor.
Nevertheless, they may still feel the need to act just because. Countering aggressive inflation expectations and keeping things under control is his mantra.
However, raising interest rates will do nothing to resolve the situation in the Strait of Hormuz. It does nothing to prevent war in the Middle East and disruption of major energy facilities in the Gulf region.
So, all this basically does is double the crushing demand as families struggle and increases the risk of economic stagnation or even recession. Especially if the conflict continues for a few more weeks/months. The impact on consumers and businesses is enormous given the time frame here.
If policymakers are not careful and act too hastily, they could even risk creating stagflation pressures. And it would be a complete disaster in 2021-22 given cautious efforts to ease inflationary pressures following the Russia-Ukraine conflict.
However this brings us to the second part of the whole issue. This is because early communications from central banks have already created the environment in which they may feel the need to respond accordingly. Even if not obvious, moving away from the previous path of interest rate cuts and opening the door to aggression is a strong signal.
And that means the market is now headed for some more rate hikes for the remainder of the year.
The fear now is that if policymakers realize that monetary policy cannot solve the problem of energy shocks, what will happen if they do not make the necessary rate hikes?
The way the markets have positioned themselves over the past weeks, this would mean easing of financial conditions. Subsequently, markets have already acted by tightening their pricing for rate increases.
Credibility concerns aside, this is a potentially dangerous situation because it risks inflation taking off, especially if we start to see second-round effects. Central banks are very afraid of that particular risk, even if the Middle East conflict ends today.
And then the issue becomes how much will they have to raise interest rates to deal with this?
A quick example is that the ECB has already cut its deposit facility rate by 2.00% this year. And policymakers have estimated that the neutral range is seen around 1.75% to 2.25%. So even with two 25 bps rate hikes, the deposit facility rate will come down to 2.50%. This is borderline just above neutral and moderately restrictive. Is this really enough to bring inflation back down, especially if we are dealing with the risk of second-round effects?
The symbolic gesture of raising interest rates before trying to cut them again next year seems like a fool’s errand. And frankly, the optics look bad because of the kind of risk they’re taking.
Thus, central banks are certainly in a very difficult position to avoid acting too early or acting too late. Any move may be considered “wrong” in the future, depending on how things go.
And that misstep risks sending the economy into recession or inflation. Balancing this is a difficult task.
However for now and this week, staying put seems to be the right move. The question, however, is how long can central banks keep waiting on the sidelines as the war drags on and inflationary pressures mount?
