The US Federal Reserve, the Bank of England, and the European Central Bank are grappling with a policy dilemma as inflation rises due to Middle East tensions but economic growth slows. With oil prices climbing again, central banks are hesitant to raise interest rates, fearing they could exacerbate economic weakness.
Inflation Trends and Oil Price Pressures
Inflation rates have been falling across the industrialized world, but concerns that the Iran war could push oil prices higher have left central banks on hold. The Fed, BoE, and ECB are still recovering from criticism of their slow response in 2022, when inflation soared above 10% in the UK and eurozone and over 9% in the US. They were accused of moving too slowly after the Ukraine war began, when post-pandemic consumer spending was already driving up prices on goods from food to construction materials.
It has been five years since these central banks met their 2% inflation targets, and now they question whether the continued blockade of the Strait of Hormuz will mean a sixth or seventh year of above-target price growth.
Federal Reserve's Review and Forward Guidance
US inflation edged lower to 3.4% in July from 3.5% in June and 4.2% in May, largely due to falling petrol prices. However, since the Bureau of Labor Statistics collected the data, Brent crude has risen again to about $90 a barrel, which will push up energy and transport costs across the US in the second half of the year. Fed officials are now asking whether inflation could climb back towards 4%, double its target.
The Fed's new boss, Kevin Warsh, has initiated a comprehensive review of the Fed's operations, based on advice from 15 outsiders he describes as eminent experts and economists. Many analysts applaud him for recognizing that a series of inflation shocks since Covid-19 have undermined central bank forecasting. Mohamed El-Erian, an economist and professor at the Wharton Business School, said Warsh is committed to long-overdue Fed reforms, which is essential for the Fed's effectiveness, credibility, and political independence.
Warsh has already ditched forward guidance, the explicit signalling of future interest rate paths, and declined to create dot plots showing expected economic and inflation developments. Among his 15 appointments is Lord Mervyn King, former governor of the Bank of England, who argues in his 2022 book Radical Uncertainty that central banks should drop the idea that consumers and businesses act like atoms in a physics experiment, as it strips out emotional responses. King describes forward guidance as "silly" when no central bank knows what interest rates will be in six months or two years. El-Erian calls it "spurious accuracy," arguing that markets need to know the "reaction function" – how the central bank will respond to different events.
Charlie Bean, a professor at the London School of Economics and former deputy governor of the BoE, says Fed watchers lack guidance on both the path of rates and the bank's likely reactions. "Warsh is getting in a bit of a mess in the way he is not giving a guide to where rates are going and also not talking about how changes in the economy will affect rates," Bean said. "It means he is not saying anything of substance." The Fed held rates in July, and markets expect a hold in September, though a rise is possible. Markets anticipate at least one, possibly two, quarter-point increases by mid-next year, taking the target rate from 3.5-3.75% to 4-4.25%.
Bank of England's Post-Covid Hangover
The BoE is considered to have acted consistently since the start of the Iran war, saying it will raise borrowing costs if inflation persists. However, its decision to hold the Bank Rate at 3.75% this year could come under pressure. The UK CPI dropped to 2.6% in June, but analysts expect it to rise to 2.9% or even 3% when July figures are published on 19 August. A majority of the nine-member monetary policy committee (MPC) are wary of raising rates when it will have little effect on global oil prices, aware that higher borrowing costs could depress the already weak UK economy.
Bean says the MPC is also under pressure from high and rising government debt. When governments are highly indebted, a central bank raising rates increases the government's debt financing bill. Central banks must decide whether to cripple government finances or let inflation remain high for longer. This is also a problem for the Fed, after the US paid the highest borrowing costs to sell 30-year bonds since 2001 in a debt auction this month.
Neil Shearing, chief economist at Capital Economics, says central banks will preside over high inflation as long as western governments cannot control debt-fuelled spending. "The conceit is that central banks need to maintain 2% as their target while at the same time tolerating a slightly higher level of inflation. They cannot say it publicly, or even privately, because they would be accused of trying to dupe the public and more importantly, the financial markets," he says. Most inflationary shocks come from global events and supply restrictions, and interest rate rises dampen consumer spending with little effect on imported goods. Nevertheless, financial markets predict the BoE will raise rates this year, possibly from September, pushing rates as high as 4.25% by late 2027.
ECB's Premature Rate Hike
Unlike the Fed and BoE, the ECB has raised borrowing costs this year, but critics say it moved too quickly. The eurozone's central bank raised interest rates in June after a modest rise in inflation caused by the Middle East war and rising oil prices. Many economists said the move was premature when much of the eurozone economy is still devastated by the energy shock from Russia's invasion of Ukraine.
Shearing said: "The ECB was clearly fighting the previous war and prematurely raising rates. The underlying picture in the eurozone is one of weakness." He is among analysts who believe financial markets are wrong to expect the ECB will raise its main deposit rate by a quarter-point to 2.5% in September and possibly again next year. He says high oil prices put pressure on inflation but also act as a brake on economic activity, as would a rate rise. A rate rise would be like kicking the economy when it is already down, and the ECB wouldn't win plaudits for that.
