How central banks will respond to the surge in energy prices

The key factors here are clearly the extent, and particularly the duration, of elevated energy prices. In the UK, for instance, if brent crude oil prices stay at USD100pb for one quarter before falling back, with a similar percentage rise in wholesale gas prices, it would lift CPI inflation by around three tenths this year.

Given that inflation has been expected to fall rapidly to the 2% target level in the next few months, we might conclude that this sort of energy price hike will only delay rate cuts; not prevent them, or turn cuts to hikes. But if oil and gas prices remain at this level for a year before falling back, the CPI impact rises to around 0.75% this year with another 0.5% in 2027. That's a whole different ball-game for the Bank and would almost certainly rule out any rate cuts and would probably force rate hikes.

The problem, of course, is that the BoE, like everybody else, does not know whether this energy price spike has longevity. Central banks like the Bank of England can't wait forever to be sure. At some point a judgement will have to come. For now, those central banks that might have been planning an imminent rate change, like the BoE will likely sit on their hands instead.

Even those that might have been planning to hike, such as the BoJ and RBA, will presumably do nothing when they hold their meetings later this month. When we look further out, it is important to consider the pre-Iran-conflict bias of the G10 central banks. The Fed and the BoE have clearly been minded to cut rates, and we'd put Norway in this camp as well. The BoJ and RBA are on the rate-hike path, it would seem, while others such as the ECB, SNB, RBNZ, Riksbank and BoC do not seem to have a strong bias one way or the other at this stage.

The market has tended to assume that those with a bias to ease, or even hold steady, will be impacted more by the surge in energy prices than those looking to hike. For instance, market-implied pricing for the Fed this year has moved towards taking out one 25-bps rate cut, with at least one 25-bps cut removed from the UK futures curve, while the market now assumes one 25-bps rate hike from the ECB this year against none before the conflict started.

In contrast, market-based predictions for BoJ rate hikes this year are practically unchanged after the spike in energy prices as traders continue to price in tighter policy. So, is it likely that monetary policy across the G10 will be tighter as a result of the conflict in the Middle East? Steven Barrow, Head of Standard Bank G10 Strategy, said that's hard to say. “We can say for sure that monetary and financial conditions will be tighter thanks to things like higher bond yields, weaker stocks, greater asset price volatility, a higher dollar, and more. On rates, central banks will probably try to look through the coming rise in CPI that's undoubtedly due to higher energy prices for as long as they possibly can”, emphasized Steven Barrow.

However, it does seem, even at this early stage, that central banks' ability to look through any inflation spike will have a limit. The crisis seems set to push energy prices up much more in our view and keep them there for a length of time that materially weighs on central bank policy choices. But will that mean higher policy rates?

“We have long argued that we do not think that the Fed should cut rates anymore, but have acknowledged that political factors could have a role to play, and so we have continued to forecast that the Fed will cut. We are not changing this yet but suspect that we will do if energy prices remain elevated for some time. In the UK too, we are reticent to drop the idea of a rate cut or two this year at this stage, not least because a lot of other forces are bringing inflation down”, said Steven Barrow.

What about the ECB? The market has priced in a hike, but here too, Steven Barrow thinks energy prices will have to stay as high, or higher, for a while yet to justify this call.