Fighting the next war

In summary:
• Central banks are likely to keep rates unchanged for some time, until they have a better sense of how inflation responds to the jump in oil prices
• It is too soon to talk about rate increases, but central banks are prepared to act
• Domestic conditions will matter, particularly whether inflation was already elevated or not.

It is often said that central banks fight the last war. This phrase takes on a different meaning when there is an actual war underway, with major implications for the global growth and inflation outlook. The last week has seen a further escalation of fighting in the Gulf, with heavy hits on oil and gas facilities that sent energy prices soaring even further. Hopes for a speedy resolution of the conflict are fading by the day. With the Strait of Hormuz still largely closed and energy infrastructure targeted by missile and drone strikes, upward pressure on the oil price has increased. The Brent crude oil benchmark closed above $110 per barrel last week, but the prices of other grades of crude and some refined products, like jet fuel, have soared even more.

It seems that only a deliberate de-escalation of the fighting by the US and/or Iran can calm energy markets. There have been mixed messages from US President Trump on this score. Sustained fighting lasting months rather than weeks will see the oil price retest the all-time 2008 high. It is against this difficult backdrop that several central banks held policy meetings last week, with the South African Reserve Bank set to take its turn this week.

Backward looking
The reason central banks are accused, sometimes unfairly, of fighting old battles is that they tend to be scarred by the mistakes they made. As the worst of the Covid pandemic faded, central banks in the developed world remained focused on the prior decade of persistently low inflation. In doing so, they missed how rapidly inflationary pressures were building. Inflation was rising steadily and across a broad front even before Russia invaded Ukraine in February 2022, sending food and energy prices surging. After initially dismissing inflation as “transitory”, monetary policymakers were forced into catching up by hiking interest rates aggressively. Higher interest rates sent markets crashing in 2022 and compounded the misery of the cost-of-living shock for households.

If central banks were to “fight the last war” today, they would fear the inflation impact of oil prices more than the economic growth knock and start raising rates. It would be an error, since the backdrop is different to 2022. The Middle Eastern supplies much more oil than Russia, therefore the potential of the oil price shock is larger, as chart 1 shows, but the broader environment is different.

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