Around the World in Central Banking, Iran War Edition

Officially, only one central bank did anything this week: The Reserve Bank of Australia (RBA) hiked rates another quarter point, this time citing inflation risk from rising energy prices and the strong wage growth that drove last month’s hike (fallacies all around, which we will get to). The Fed, Bank of England (BoE) and European Central Bank (ECB) all stood pat. However, there were some interesting developments under the surface for investors to weigh.

Starting with the Fed, headlines’ main question entering Wednesday’s announcement was whether policymakers would see more risk to growth, teeing up future cuts, or inflation—opening the door to future hikes. The brief policy statement leaned seemingly toward the former, saying the Federal Open Market Committee (FOMC) “is attentive to the risks to both sides of its dual mandate” but called out “elevated” economic uncertainty. Yet to us, this was hardly the most interesting nugget. These policy statements are designed to be squishy and noncommittal, and it would be a mistake to interpret Fedspeak as signaling any future policy path. Their decisions are always data dependent. Nothing on that front really seems to have changed.

What did change: Governor Christopher Waller voted with Chair Jerome Powell and the majority to hold rates. At January’s meeting, Waller was one of two dissents from the decision to hold, voting for a quarter-point cut. At that time, he was also on President Donald Trump’s shortlist to replace Powell. Two days later, Trump nominated former Fed Governor Kevin Warsh instead. Did war change his tune? Does he no longer see a need for a cut to bolster growth? Or does he no longer see a need to signal his rate-cutting bona fides to the White House? Either way, it cuts against claims an FOMC stacked with Trump picks will cut rates aggressively.

More interestingly, and in perhaps the biggest single piece of news from the meeting: Powell offered more clarity about his future. He stated he intends to remain as interim Chair should Warsh not be confirmed when his term officially ends in May, following precedent. That hasn’t silenced chatter that Trump may try to nominate Stephen Miran as temporary Chair in that scenario, but that also gets weird since Miran’s term expires in May and Warsh would be taking his seat.

Typically, if a Fed Governor’s term expires before his or her replacement is confirmed, the seat is vacated and empty until the Senate votes. So this is a bit of a wildcard, with Warsh’s confirmation hearing not on the docket yet, but we are gradually getting clarity. We are also getting clarity on Powell’s longer-term status, as his term on the Fed board doesn’t end until 2028. He confirmed he will stay on at least until the Department of Justice’s investigation is fully complete and over, with question marks after that. So the FOMC’s balance won’t change much. Those who expect the Fed to bow to Trump’s whims (for better or worse) should take note. Powell’s staying on would limit his influence over the FOMC even more than the basic structure already suggests.

Across the pond, the mood was more hawkish. While the BoE and ECB kept rates on hold, their remarks and forecasts were tough enough that market-based expectations flipped from more rate cuts later this year to a couple rate hikes. Both lifted their inflation forecasts, with the ECB’s worst-case-scenario projections of the Iran War’s effect on prices estimated at a 6.3% y/y inflation rate.

To us, it seems they—along with RBA Governor Michele Bullock—are fighting the last war. Everyone seems hung up on 2022, when inflation spiked alongside higher oil and national gas prices after Russia invaded Ukraine. Central bankers seem very keen to avoid a repeat. Then, they were criticized for being behind the 8-ball. Reoffending would be a PR nightmare.

Problem is, now isn’t then. Hot inflation in 2022 didn’t erupt because of energy prices. It was a lagging aftereffect of massive money supply spikes as central banks battled COVID lockdowns’ economic effects in 2020. Throwing double-digit money supply growth at economies that couldn’t produce anything created the classic inflation recipe: too much money chasing too few goods and services. Post-pandemic supply chain chaos in 2021 and 2022 fed into this, extending shortages as economies proved more difficult to turn on than they were to turn off.

This time, we don’t have spiking money supply. US M4 growth (the broadest money measure) topped 30% y/y in mid-2020.^[i] Now, it runs at a tame 5.0% y/y.^[ii] Eurozone M3 growth peaked at 12.8% y/y in January 2021.^[iii] Now it is 3.3% y/y.^[iv] UK M4 growth surged to 15.1% y/y in February 2021 but now sits at 3.6%.^[v] This isn’t tinder for hot inflation.

Absent surging money supply, higher energy prices prompt substitution. Households will scrimp here and there to afford higher heating, air conditioning and gasoline costs. That scrimping reduces demand for other goods and services, which tugs prices down. And while companies might try to embed their own rising energy costs into the price of goods and services they sell, those rising prices prompt the same substitution decisions at the household level. Supply and demand end up keeping broad CPI in check.

Which means there isn’t really anything for central banks to do. Rate hikes seem more about PR than a viable strategy to rein in prices. Rate hikes can’t transport oil and liquefied natural gas (LNG) through the Strait of Hormuz. They can’t block drones and missiles from hitting gas plants in Qatar. They can’t halt attacks on oil fields and export terminals. This is all outside of central banks’ control. Yet so are the solutions to these obstacles, like the pipelines helping reroute Saudi oil away from the Strait. And the US waiving the Jones Act to help get more oil and gas moving. And tankers’ rerouting to avoid the chaos. These are all parts of markets’ natural adaptation, and we think they are a big reason why natural gas prices remain far below their 2022 highs in Europe and Asia.

We do see a small risk to watch here: If central banks overshoot while hiking rates for the wrong reasons and invert the yield curve, that could invite recession. We aren’t there yet, nor is it close, and it looks like bond markets are pricing all of this in. Things are working as they should. But it is worth watching and weighing as we move forward, because while we continue to believe the war itself isn’t a risk to global GDP, considering its tiny direct economic footprint, human reactions are a wildcard.