The conflict in Iran has triggered an energy shock, leading to a significant tightening of financial conditions in the US and Europe. By pushing up interest rates and oil prices, the market has effectively completed the central banks' 'rate hike task' in advance. Amidst risks of stagflation and leadership transitions, policymakers are adopting a wait-and-see approach.
In response to the energy shock triggered by the Iran war, how should global central banks adjust interest rates? For now, the standard answer might be: remain silent and wait and see.
Although major monetary authorities have so far only engaged in 'verbal posturing,' warning that decisive action will be taken if necessary, in reality, global financial conditions have already tightened significantly. The combined effects of soaring energy prices, rising borrowing costs, increases in mortgage rates, widening credit spreads, and falling stock markets have led to a substantial tightening effect.
Data from the Chicago Fed shows that the tightening of the U.S. National Financial Conditions Index in March marked the sharpest monthly increase since Trump announced comprehensive tariff policies in April of last year, reaching its highest level of tightness since May of the same year. Prior to this, only the regional banking crisis in March 2023 and the intensive rate-hike cycle by the Federal Reserve between 2022 and 2023 had caused more severe market squeezes. The financial conditions indices for the U.S. and the Eurozone compiled by Goldman Sachs also corroborate this trend, with the Eurozone index surging to a 10-month high.
The effectiveness of central bank policy adjustments lies in their ability to change the actual borrowing costs for households and businesses. If the market has already accomplished this by increasing loan costs, pushing up mortgage rates, lowering stock prices, and squeezing consumption through higher energy costs, then the anticipated effects of an interest rate hike have already been partially achieved.
Since the US and Israel launched strikes against Iran on February 28, the market has already priced in the possibility of two rate cuts that may not materialize this year. $U.S. 10-Year Treasury Notes Yield (US10Y.BD)$ Yields climbed more than 40 basis points, while the 30-year fixed mortgage rate surged to 6.4%. Meanwhile, retail prices for regular unleaded gasoline rose by one-third.$S&P 500 Index (.SPX.US)$This was accompanied by a pullback of more than 7%.
In short, the degree of market tightening is no less impactful than an actual interest rate hike, which is why the Fed's communication strategy carries such weight.
The crux of the issue is that when a central bank commands sufficient credibility in the market, its forward guidance can unleash tremendous power. In his speech on March 18, Fed Chair Powell echoed the classic statement made by former ECB President Draghi, asserting that the Fed would do 'whatever it takes' to address the surge in oil prices. While acknowledging the uncertainty over how long the oil price shock would last, he explicitly stated: 'We are prepared to take the necessary actions.'
Powell and his colleagues’ tough rhetoric successfully prompted the market to withdraw bets on future rate cuts. Considering that core inflation in the U.S. remains one percentage point above target and the economy is gaining momentum, this correction to previously accommodative financial conditions is welcomed by policymakers.
The subtlety at present lies in the fact that the Fed has not yet taken any action, and the market also expects it to remain on hold temporarily. However, substantial tightening has already occurred. Although there is a risk that 'the market eventually sees through the central bank’s bluff,' this moment seems far off for now, as long-term inflation expectations on both sides of the Atlantic remain near their two-year averages.
The debate over the next steps continues: Will this energy crisis lead to inflation by driving up prices, or result in a recession by weakening demand? As IMF economists have noted, 'All roads lead to higher prices and slower growth.'
Historical experience seems inadequate at this juncture. The current situation bears no resemblance to the oil crises of the 1970s or 1980s, as energy efficiency, technological advancements, and wage negotiation mechanisms have undergone profound transformations. Even compared to the impact following Russia-Ukraine conflict in 2022, the present policy environment is markedly different.
Nonetheless, the largest single-month surge in oil prices in history will inevitably trigger an inflationary impulse. Germany’s March inflation data serves as evidence: its year-on-year CPI growth jumped significantly from 2.0% in February to 2.8%, while European households’ inflation expectations nearly doubled, reaching their highest level in four years.
However, Gilles Moëc, Chief Economist at AXA Group, cautioned against repeating the European Central Bank's 'mistake' from 2011. At that time, the ECB prematurely raised interest rates in response to rising oil prices and tightening labor markets, only to be forced into an abrupt reversal during the subsequent Eurozone debt crisis. Moëc emphasized that the impact on long-term interest rates was a lesson policymakers must heed.
Moreover, the ability of central banks to guide markets toward policy objectives largely hinges on whether their independence is compromised by political interference. Despite Kevin Warsh, appointed by Trump, set to assume the role of Federal Reserve Chair in May, markets temporarily erased expectations for rate cuts this year, reflecting continued trust in the Fed's independence. Whether this trust can withstand scrutiny will be a focal point at next month’s congressional hearings.
Editor/Rocky