The Hormuz Dilemma for Central Banks
For the Federal Reserve and the ECB, the time has come to decide whether to continue treating price increases caused by the Iran crisis as temporary. A commenary by Lorenzo Bini Smaghi
The moment of decision is approaching for central banks. The next meeting of the Governing Council of the European Central Bank will take place on June 11. The following week will see meetings of the US Federal Reserve, the Bank of England and the Bank of Japan.
The issue will be the same everywhere: whether and when to raise interest rates to confront inflation caused by higher energy prices, following the outbreak of the war in Iran and the closure of the Strait of Hormuz.
The case for a wait-and-see approach rests on the fact that, at least for now, inflation is due only to supply-side factors: the fall in the production of raw materials, especially gas and oil.
Price increases have not yet been passed through to other costs, nor to other consumer prices. In economic terminology, second-round effects have not yet materialised — the kind that could turn increases in the prices of some goods into a generalised inflationary phenomenon.
In this context, an increase in interest rates could produce an excessive monetary tightening, further slowing economic growth. The central bank should therefore wait until it sees inflation rising in non-energy sectors as well before taking any decision.
The problem is that monetary policy affects inflation with an average lag estimated at around 12 to 18 months.
If a central bank acts by looking in the rear-view mirror, waiting until inflation has already risen and become embedded in the behaviour of economic agents, it risks acting too late. To catch up, it would then have to raise rates sharply, with even more costly effects on economic activity. This is precisely the mistake central banks made in 2022.
What matters in deciding whether or not to raise interest rates is not the latest available data point, but the inflation forecast over the next two years. In producing these forecasts — the next ones will be published on June 11 — the central bank must take into account a whole range of indicators.
One of these concerns the intensity and duration of the rise in raw material prices.
Oil prices have been above $100 for more than two months, an increase of around 30 per cent compared with the first months of the year, and are expected to remain above that level at least until the end of the summer.
Even if the Strait of Hormuz were reopened soon, it would take a long time to restore prewar production capacity.
The longer the energy shock lasts, the greater the likelihood that it will affect other cost components and be transmitted to the headline price index.
Another indicator concerns the inflation expectations of economic agents. The latest figure, dating back to March, shows a jump to 4 per cent in the euro area, the sharpest increase since 2021. This signals that economic agents are already incorporating higher inflation into their behaviour.
Inflation expectations can also be inferred from developments in medium- and long-term interest rates. Since the start of the war in Iran, three-year rates on the most liquid securities have risen by around 60 basis points; five-year rates by around 40.
This development also reflects the expectation that fiscal policies will become more expansionary, in order to offset the effects of higher energy prices, as confirmed by recent calls for greater flexibility in the interpretation of the Stability Pact. If these requests were granted, the supply shock would be accompanied by an equivalent demand stimulus, accentuating the inflationary shock.
Finally, keeping the interest rates set by the European Central Bank at their current level, at a time when inflation is expected to rise well above 2 per cent, would create increasingly accommodative monetary conditions, fuelling price pressures on goods and services.
Therefore, if the forecasts do not indicate a rapid absorption of inflation over the next 12 months, a moderate increase in interest rates would become inevitable.
It is harder, however, to justify, in the current context, the ECB’s insistence on continuing to reduce the size of its balance sheet through quantitative tightening — the policy of not reinvesting the securities in its portfolio as they mature — which puts pressure on long-term interest rates.
It would be wiser to take a pause, as all the other central banks have already decided to do.
A previous version of this article was published in the Italian daily Il Foglio
IEP@BU does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
