A cautious and observant approach as an initial measure
In this uncertain context, an immediate reaction from central banks was neither expected nor warranted, whether in the form of a rate cut to mitigate the downside risk to growth, or a rate hike to counter the upside risk to inflation. Caution and a wait-and-see approach were the order of the day and largely prevailed. The vast majority of central banks have not deviated from their planned (or expected) decisions, with only a few making minor adjustments to their previously anticipated course.
This situation is exemplified by the Central Bank of Brazil (BCB), which opted for a 25-basis-point rate cut instead of the 50-basis-point cut initially planned. While the initiation of monetary easing was not called into question, its extent was indeed reduced[2]. A similar scenario may apply to the 25-basis-point rate hike by the CBI (Central Bank of Iceland). Would this hike have taken place without the war in the Middle East? It is conceivable that it would not. Before the outbreak of the conflict, the trade-off between signs of weak growth and rising inflation argued for maintaining the status quo. The conflict and the subsequent rise in price pressures likely tipped the balance in favour of tightening.
The most striking outcome is probably that of the Bank of England (BoE). A rate cut was neither guaranteed nor widely expected, but just a few days before the meeting, we were forecasting a 25bp cut to align with growing signs of disinflation. However, in light of recent events, we revised this forecast in favour of a hold. And the decided status quo was ‘resounding’, with all nine members voting unanimously for the first time since September 2021, thereby reinforcing the hawkishness signal.
Meanwhile, the Reserve Bank of Australia’s (RBA) 25bp rate hike is part of a trend that began in February, in response to signs of a resurgence in inflation prior to the current energy shock, which is specific to Australia. The February hike attracted attention as it was the first among the major central banks of developed countries[3], raising questions about its potential knock-on effects.
The Bank of Canada (BoC), the US Federal Reserve (Fed), the Bank of Japan (BoJ), the Swedish Riksbank, the Swiss National Bank (SNB), the Bank of England, the European Central Bank and numerous central banks in emerging economies opted for the status quo, as expected. For the Fed in particular, this appears to be a forced pause.
However, the nature of this status quo has changed in the current context. It is now accompanied by a notable and logical shift in tone, marked at the very least by increased vigilance regarding the re-emergence of inflationary risk and, for roughly half of our sample, by a hawkish bias, i.e. the readiness / willingness to hike if needed to mitigate this risk. The ECB is among them.
Uniformity of reactions at present; diverging reactions to follow?
What happens next remains to be seen, but the trajectories of monetary policy could become more varied. Firstly, although the shock is global and spares no one, its impact is likely to vary considerably due to different levels of exposure among countries[4]. Secondly, the starting points differ from one country to another. The task facing central banks in countries where inflation is low (such as Switzerland and Sweden) is therefore less complicated than in countries where inflation was already high and sticky, while also facing upside risks (the United States, to name but one). The starting point in terms of growth naturally matters too, and in this regard, the US is in a more favourable position than the eurozone.
The central bank’s actions will also depend on the measures taken by governments. On the one hand, fiscal support (which is very limited at present) may help to mitigate the disinflationary effect of the negative demand shock, thereby further complicating the task facing monetary authorities. On the other hand, this same support, if aimed solely at limiting the rise in energy prices rather than directly bolstering demand, would help to reduce observed inflation. This, in turn, would mitigate the risk of inflation expectations becoming unanchored and prevent other second-round effects.
In any case, central banks face the same dilemma to varying degrees: as the conflict constitutes a classic negative supply shock, which simultaneously pushes inflation up and growth down, should they respond by raising interest rates to contain inflation, at the cost of further weakening growth, or should they lower interest rates to stimulate growth, thereby fuelling inflation? The central banks’ response will depend not only on their own reaction functions but also on which risk manifests first and with what intensity.
Economic theory posits that the best response to an energy shock affecting an economy in equilibrium is to do nothing. Faced with an exogenous negative supply shock of this kind, central banks can, in fact, only manage the consequences, as they lack the ability to influence the causes. Assuming these consequences remain limited, central banks may simply look through them. However, while doing nothing may seem sensible in theory, it is not necessarily the most suitable response in practice, as highlighted by Jerome Powell. In the current situation, it is difficult to determine the precise scale of the consequences, yet there is little doubt that the risk of inflation has returned. The adjustments in central bank forecasts currently available to us bear this out: inflation forecasts have been revised upwards more than growth forecasts have been revised downwards.
As the future trajectory of inflation is currently a greater cause for concern than that of growth, we should expect interest rate hikes[5]. This is now our scenario for the ECB (three hikes of 25 basis points in June, July and September). For the BoJ, we maintain our expectation of a further 25 bp hike in April. For the BoE, a rate hike as early as April cannot be ruled out, but it is contingent on the severity and duration of the ongoing energy shock. Therefore, our BoE call remains under review. Should the stagflationary shock prove limited, the status quo – of a very different nature from what was envisaged hitherto – could be extended to navigate between the two risks. This is the scenario we are currently adopting for the Fed.
