ROI-Central banks risk losing another battle by trying to win the last war: Mike Peacock

By Mike Peacock

LONDON, April 7 (Reuters) - On the face of it, the Middle East energy crisis is precisely the sort of external shock that central banks should "look through". But there are growing reasons why that may not happen this time around.

The U.S.-Israeli war on Iran that began on February 28 has sent Brent crude LCOc1 up about 50% to $108.50 a barrel, raising the risk of an inflationary spike globally. In theory, central banks should avoid changing policy in relation to this event unless it’s clear that it will persist or boost inflation expectations long term.

The Bank for International Settlements – a group that promotes financial stability among central banks – has urged policymakers not to rush to action, calling the current crisis a textbook case of when to "look through" a supply shock.

Central banks may not heed this advice. They are still stinging from the criticism – fair or not – that they moved too slowly after Russia’s 2022 invasion of Ukraine, mistakenly labelling elevated inflation “transitory” only to see it remain above target for years.

On top of this, the claim that inflation expectations in developed markets are “well anchored” – something central bankers have long reiterated – is now questionable.

The world has witnessed a succession of “black swan” events in recent years that risk structurally elevating inflation expectations, leading to an upward spiral of ever higher prices and greater wage demands.

First, there was the COVID-19 pandemic – supposedly a once-in-a-century shock – that led to a significant jump in prices as snarled supply chains were coupled with a stimulus-driven demand surge. That was swiftly followed – and exacerbated – by a global energy jolt caused by Russia’s full-scale invasion of Ukraine. Now that conflict has been compounded by a fresh shock: the war in the Middle East.

Amid all this, the globalised trading system that suppressed inflation for decades has been fractured by U.S. President Donald Trump's tariff wars.

Put that all together, and it starts to look like policymakers won’t be able to sit on their hands for long – whether or not that’s the appropriate choice.

THE CASE FOR CAUTION

The Bank of England, Federal Reserve and European Central Bank all held rates steady at their most recent policy meetings. But there was little indication that they would be “looking through” the current energy crisis. Instead, the communication seemed designed to send the opposite message.

“We're well aware of the performance of inflation over the last few years and how a series of shocks have interrupted progress that we've made over time,” Fed Chairman Jerome Powell said last month.

The BoE’s policy meeting minutes from March 19 warned that “households and businesses could have a heightened sensitivity to any new inflationary shock, following successive negative supply shocks in recent times.”

And the ECB said on the same day, “If persistent, higher energy prices may lead to a broader increase in inflation through indirect and second-round effects, a situation which requires close monitoring.”

Central banks may feel compelled to act unless the Strait of Hormuz, the global energy artery currently blockaded by Iran, fully reopens soon. But recent history should give policymakers pause for thought.

Alan Taylor, an external member of the BoE's Monetary Policy Committee, recently discussed a thought experiment he and his colleagues conducted, asking what central bankers might have done from 2020 onwards if they were solely focused on bringing inflation back to target, with no concern for the knock-on growth effects.

In his scenario, UK rates would have exceeded 10% in 2023 instead of peaking at 5.25%, and would still be around 7% today, triggering a deep recession … and inflation still would have hit 7%.

That’s just one scenario, but the situation today calls for caution for other reasons as well.

For one, the starting point for rates is quite different than it was after the pandemic. Back then, interest rates were close to zero. Today, the Fed’s policy rate is 3.5-3.75%, and the BoE’s is 3.75%. Both have indicated they view their respective rates as somewhat restrictive. The ECB has signalled readiness to hike its 2% key rate to combat rising inflation risks.

WAIT AND COMMUNICATE

The lesson from the post-pandemic inflation surge is not necessarily to act faster, but to communicate better. There were errors back then, particularly the insistence that the leap in prices was “transitory”, but central banks are clearly being more careful about the projections they make this time around.

Both the ECB and BoE have introduced scenarios showing what could happen to the economy under different conditions.

In its annual Stress Test Scenarios , published in February , the Fed used a 2.2% inflation projection for its baseline and a much lower 1.0% for its severely adverse scenario, which typically models a demand-shock recession. They would presumably look very different if conducted now.

The ECB’s baseline puts inflation at 2.0% next year, its adverse scenario projects 2.1%, while its severe scenario is 4.8%. Only the latter signals the need for rate rises. The BoE will publish its equivalents at the end of April.

If underpinned by an unwavering commitment to deliver the inflation target – not now but over the medium term – such scenarios could help anchor inflation expectations without central bankers having to rapidly pull the policy lever.

They should also be wary of overreacting to credibility concerns. By responding more nimbly to the situation at hand – rather than trying to fix mistakes made in the past – policymakers could actually enhance their reliability.

Regarding the BoE, David Aikman, director at the UK’s National Institute of Economic and Social Research, recently said, “Credibility is not demonstrated by reacting mechanically to a number the Bank cannot control. It is demonstrated by being clear about what the Bank can control, what it is watching, and what it will do if the situation deteriorates.”

Ultimately, if central bankers focus on trying to win the last war instead of responding to the reality of the current one, they risk being accused of making a major policy mistake yet again.

(The views expressed here are those of Mike Peacock, the former head of communications at the Bank of England and a former senior editor at Reuters.)

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