How will the Fed respond to the Iran war’s fallout?
Market Questions is the FT’s guide to the week ahead
Investors will be laser focused next week on commentary from Federal Reserve chair Jay Powell about how the Fed views the risks to inflation and growth, as central bankers try to gauge the economic fallout from conflict in the Middle East
Higher oil prices are expected by some analysts to contribute to a stagflationary environment in the US economy — a combination of inflation and stagnant economic growth that is difficult to combat under the Fed’s dual mandate to keep prices low and employment high.
“It’s yet another stagflation shock,” said Stephen Douglass, chief economist at NISA Investment Advisors. “You have to pick a side and which side of the mandate Powell emphasises will be the first signal.”
Still, uncertainty over how long the conflict will go on means the Fed is likely to deviate little from its current policy.
“They’re firmly on hold. That will allow them to get clarity on what’s happening in the war and in the oil market,” Douglass said.
Traders in futures markets have turned more hawkish since the war began and anticipate only a single quarter-point cut from the Fed by the middle of 2027. It marks a dramatic shift from two weeks ago, when they expected two quarter-point cuts this year. Jill R Shah
Is the ECB still ‘in a good place’?
The European Central Bank’s monetary policy meeting on Thursday has become much more interesting than policymakers would have wished a couple of weeks ago. A longstanding consensus that borrowing costs would hold steady for the foreseeable future has been trashed.
Economists at Goldman Sachs predict that headline inflation in the Euro area will rise to almost 3 per cent in the second quarter, from 1.9 per cent in February. Traders in swaps markets have priced in at least one quarter-point increase in interest rates by the end of this year. Before the war, they were pricing a roughly 50 per cent chance that the ECB would resume the cutting cycle it began in 2024.
Many observers reckon the trauma of runaway inflation after Russia’s full-scale invasion of Ukraine in 2022 could trigger a more hawkish ECB response to the present crisis. But few if any expect it to act on Thursday. Traders in swaps markets are pricing a 90 per cent chance that it will leave borrowing costs unchanged at 2 per cent for the sixth meeting in a row.
Before they make any move, policymakers will want a better understanding of how long the conflict and its disruption to energy markets will last, given their tendency to “look through” short-term supply shocks. Moreover, while high energy prices will fuel inflation, they will also slow economic growth, and at least to some extent keep price pressures in check.
ECB president Christine Lagarde would adopt “a decidedly wait-and-see approach for now”, BNP Paribas economists wrote in a note to clients. However, they added, Lagarde was likely to ditch her mantra that monetary policy is “in a good place” and instead stress that the ECB “won’t hesitate to act to ensure price stability if required”. Olaf Storbeck
Will inflation expectations force the BoE’s hand?
Like the Fed and the ECB, the Bank of England is widely expected to leave its policy interest rate unchanged at its meeting on Thursday as it grapples with the price pressures and uncertainty unleashed by the war in the Middle East.
Traders in swaps markets are pricing an 80 per cent chance that the BoE will deliver one quarter-point rate rise by the end of this year — a sharp turnaround from the two quarter-point rate cuts that were fully priced in before the US and Israel began their bombardment.
UK inflation was previously on track to return to the BoE’s 2 per cent target by the middle of 2026. The sharp rise in global energy prices and the risk of second-round effects have put this in jeopardy.
David Miles, senior economist at the Office for Budget Responsibility, said UK inflation could be on track to end the year at about 3 per cent if oil and natural gas prices remained at their current elevated levels, rather than declining to 2 per cent as previously forecast.
Edward Allenby of Oxford Economics said the BoE’s Monetary Policy Committee “will be wary about the risks of making a policy error and is likely to err on the side of caution for now”.
If the energy shock proves shortlived, some economists say the BoE should be able to resume its cutting cycle before the end of this year. However, policymakers may be cautious about the risk of higher price growth as household inflation expectations are still above the 2010-2019 average, with consumers still feeling the strain of elevated inflation.
“The MPC will want to lean against the risk that less well-anchored inflation expectations move higher in response to a new supply shock, as this would help to lessen the likelihood of strong second-round effects forming that could keep inflation elevated for longer,” said Allenby.