Escalating tensions in the Middle East are fundamentally altering the policy direction of central banks worldwide. On Thursday, March 19, major global central banks held interest rates steady but simultaneously issued hawkish policy signals. The Federal Reserve raised its inflation forecasts, while the Bank of England and the European Central Bank expressed significant concern over the conflict in the Middle East. The Bank of Japan also warned of the need to remain vigilant about rising oil prices' impact on inflation.
Energy prices are at the core of the current inflation expectations. Since the outbreak of the Middle East conflict, European natural gas prices have nearly doubled.
Notably, Bank of England Governor Andrew Bailey explicitly stated that the central bank is prepared to act if inflation shows signs of persisting at elevated levels. Investors quickly repriced their expectations, shifting from two anticipated rate cuts to three potential rate hikes within the year.
On Thursday, the yield on the 2-year UK government bond surged by more than 30 basis points, bringing the total increase since the start of the U.S.-Iran conflict to nearly 100 basis points.
However, some analysts remain cautious about the market's reaction. Anna Titareva, an economist at UBS Investment Bank, suggested the market may be overreacting, stating it was an exceptionally volatile day and that she does not believe there will be two or more rate hikes this year.
Central banks held rates steady, but policy signals turned notably more hawkish.
The European Central Bank, the Bank of England, the Swiss National Bank, and Sweden's Riksbank all kept interest rates unchanged on Thursday. Earlier in the week, the Federal Reserve, the Bank of Canada, and the Bank of Japan made similar decisions to maintain current policy settings.
Beneath the surface of unchanged rates, the policy rhetoric from Europe's two major central banks showed a substantial shift. ECB President Christine Lagarde stated during a press conference that the war in the Middle East has significantly increased uncertainty, posing upside risks to inflation and downside risks to economic growth.
Bank of England Governor Andrew Bailey was more direct, emphasizing he will monitor developments very closely and stands ready to take necessary action to ensure inflation continues moving toward the 2% target.
Although the Middle East conflict poses a threat to the global economy, Europe is considered one of the most vulnerable economies due to its high dependence on energy imports. The near-doubling of European natural gas prices since the conflict began has directly influenced the ECB's assessment of the inflation trajectory.
The ECB not only raised its annual inflation forecast but also revised upward its core inflation projections for the next three years. Core inflation excludes volatile energy and food prices, indicating the central bank expects the energy crisis to translate into broader price pressures.
Central bank officials acknowledged that it is still too early to determine the full economic impact of rising energy costs. However, they have begun preparing for scenarios where supply disruptions last longer than initially anticipated.
Lagarde also emphasized that the eurozone entered this crisis from a position of relative economic strength, with a solid labor market and inflation previously close to the 2% target. She noted the region has a good starting point, is well-prepared, and possesses the necessary tools to confront this significant shock.
Lessons from the Russia-Ukraine conflict keep policymakers on high alert.
Part of the reason for the ECB's shift toward a more proactive policy stance stems from lessons learned following the outbreak of the Russia-Ukraine war in 2022.
From a traditional policy framework, the standard response to a supply shock is to "look through it," as price shocks are often temporary, and raising interest rates can do more harm to growth than good for curbing inflation.
However, during the Russia-Ukraine conflict, sharp increases in energy and food prices triggered significant wage demands, driving up prices across labor-intensive service sectors and resulting in inflation remaining above target for much longer than expected.
This memory remains fresh, and policymakers worry that if energy prices rise again, workers may quickly demand higher wages, potentially triggering a new round of price increases. Lagarde explicitly pointed out that inflation expectations are closely tied to the recent memory of inflation among people and businesses, a memory that is still quite fresh.
For the ECB and the Bank of England, the key questions are how long the current rise in energy costs will last and to what extent it will spill over into other goods and services. The answers will largely determine the direction of monetary policy in the coming months.
