Inflation hangs like a sword overhead, as central banks worldwide collectively turn hawkish.

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The escalation of the Middle East situation is fundamentally changing the global central banks’ policy orientation.

On Thursday, March 19, WallstreetCN mentioned that while major global central banks are keeping interest rates unchanged, they are sending out hawkish policy signals. The Federal Reserve raised its inflation outlook, the Bank of England and the European Central Bank expressed high concern about the conflict in the Middle East, and the Bank of Japan said it must be alert to the impact of rising oil prices on inflation.

Energy prices are at the core of inflation expectations this time. Since the outbreak of the Middle East conflict, European natural gas prices have nearly doubled.

(Since the outbreak of the Middle East conflict, European natural gas prices have nearly doubled)

It is noteworthy that Bank of England Governor Bailey made a clear statement that if inflation continues to rise, the central bank is prepared to take action. Investors quickly repriced this year’s Bank of England expectations from two rate cuts to three rate hikes.

On Thursday, the yield on 2-year UK government bonds rose by more than 30 basis points, and has accumulated nearly 100 basis points since the start of the US-Iran conflict.

(The yield on 2-year UK bonds soared, signaling stronger rate hike expectations)

However, some analysts are cautious about the market reaction. Anna Titareva, an economist at UBS Investment Bank, believes the market has overreacted. She said:

It’s been an exceptionally volatile day. We don’t believe there will be two or more rate hikes this year.

Central banks stand pat, but policy signals turn notably hawkish

The European Central Bank, Bank of England, Swiss National Bank, and Riksbank all kept rates unchanged on Thursday; the Federal Reserve, Bank of Canada, and Bank of Japan also stood pat earlier this week.

Yet beneath the surface of unchanged rates, there has been a substantive shift in the wording of Europe’s two major central banks’ policies. ECB President Lagarde said at a press conference on Thursday:

The Middle East war has significantly increased uncertainty for the outlook, bringing upward risks to inflation and downward risks to economic growth.

Bank of England Governor Bailey’s statement was even more direct:

I will monitor developments very closely and am ready at any time to take necessary actions to ensure inflation continues moving toward the 2% target.

Although the Middle East conflict poses a threat to the global economy, Europe is seen as one of the most vulnerable economies due to its heavy dependence on energy imports. Since the outbreak of the conflict, the near doubling of European natural gas prices has directly influenced ECB assessments of the inflation trajectory.

The ECB not only raised its annual inflation forecast but also increased its projection for core inflation over the next three years, which excludes energy and food prices. The forecast shows the institution expects the energy crisis to transmit to broader price pressures.

Central bank officials admit it is too early to judge the ultimate impact of rising energy costs on the economy at present. But they have begun preparing for scenarios in which supply disruptions persist longer than expected.

Lagarde also stressed that the euro area entered this crisis with relatively robust fundamentals, a solid labor market, and inflation previously close to the 2% target. She said:

Our starting point is good; we are fully prepared and have the tools to deal with this major shock.

Lessons from the Russia-Ukraine conflict keep policymakers vigilant

The more proactive policy stance of ECB officials is partly due to the hard lessons learned from the outbreak of the Russia-Ukraine conflict in 2022.

In traditional policy frameworks, the standard response to supply shocks is to "ignore them," since price shocks are usually temporary and rate hikes do less to curb inflation than they do to harm economic growth.

But during the Russia-Ukraine conflict, surging energy and food prices triggered steep wage demands, pushing up prices across labor-intensive services and causing inflation to persist well above target levels for longer than expected.

This memory is still fresh. Policymakers worry that if energy prices rise again, workers may quickly demand higher wages, triggering another round of price increases. Lagarde pointed out on Thursday:

Inflation expectations are closely tied to people's and companies' memory of inflation. And now that memory is quite fresh, because people have personally experienced inflation.

For the ECB and Bank of England, the question is how long the current rise in energy costs will last, and to what extent it will spread to prices of other goods and services. This will largely determine the direction of monetary policy in the coming months.

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