It is unusual for so many of the world’s most important central banks to meet in the same week, as the Fed, the ECB, the Swiss National Bank, the Bank of England, the Bank of Japan, the Swedish Riksbank and the Royal Bank of Australia have just done.
It is rarer still that they confront a broadly similar exogenous shock, even if higher oil and gas prices affect their economies to different degrees. In essence, they face the same question: should the current spike in energy prices be treated as transitory and warrant inaction?
Central banks should look through transitory shocks to inflation
Monetary policy, and its main instrument the policy rate, are designed chiefly to manage demand against a relatively stable supply backdrop. Supply shocks – such as energy shortages and surging prices – complicate that task as they push inflation higher along-side weaker growth. That leaves policymakers in a bind. Rising energy costs and higher inflation argue for tighter policy. Yet they also erode households’ real incomes and dampen spending, suggesting more policy support.
Central banks typically look through temporary shocks. Policy works with long lags and thus might affect the economy only after the shock has dissipated or reversed. So, acting too quickly risks amplifying, rather than smoothing, macroeconomic volatility. This helps explain why many advanced-economy central banks were slow to tighten after the pandemic-era supply bottlenecks of 2020–21 and after the energy shock following Russia’s invasion of Ukraine in 2022. But inaction is not always optimal. If inflation expectations shift upwards, or if wage-price spirals take hold, short-term shocks can morph into persistent inflation. In such cases, policymakers must respond.
Households could revise up their inflation expectations
Households have now endured three negative supply shocks in five years – four shocks in the US if we account for the tariff shock. The danger is that they begin to treat such disturbances as the new norm, adjusting wage demands and price expectations accordingly. That would make it harder for central banks to meet their inflation targets over the medium term.
There is no simple rule for identifying when inflation expectations become unanchored. But given that expectations are partly backward-looking, at least for households, the risk rises the longer inflation remains above target. While market measures of long-term inflation expectations have been quite stable, consumer surveys have drifted higher across many advanced economies. This likely reflects both the sharp increase in price levels since the pandemic and persistently above-target headline inflation since 2022 – especially in the US, the euro area and the UK. Should the current oil shock prove prolonged, expectations in these economies could rise further, forcing a more hawkish response than in countries such as Switzerland, where inflation has been below the 2% bar for almost three years.
Existing economic slack should dampen second-round effects
Much depends on economic slack. Second-round effects of an energy shock are likely to be smaller where spare capacity exists. Unlike 2022–23, when labour markets were tight and wages surged, most economies now show some slack, particularly in Europe. The United States may be an exception, with output still running above potential.
Weaker exchange rates add to inflationary pressures
Exchange rates matter too. So far, currencies have moved largely as expected: those of net energy importers have weakened against the dollar, reflecting a deterioration in their terms of trade. If the conflict intensifies, the Swiss franc is likely to fall less than other currencies, supported by its safe-haven status and thereby cushioning imported inflation.
Lower energy intensity dampens passthrough from higher oil prices depends on
Passthrough from higher energy prices to inflation also depends on the energy intensity of each economy. In Switzerland, for instance, energy in households’ consumer baskets accounts for roughly half the share in the euro area, which helps explain why higher oil prices feed through less strongly into inflation.
The Fed is reluctant to hike rates if higher oil prices persist
Finally, mandates differ as well. The Fed stands apart. Whereas most central banks focus solely on price stability, it also aims to maximise employment. A stagflationary shock pulls those objectives in opposite directions. Its response will therefore depend on how policymakers weigh the risk of higher inflation against that of a weakening labour market. All else equal, this makes the Fed less likely than its peers to hike rates, at least initially.
By Raphael Olszyna-Marzys, international economist at J. Safra Sarasin Sustainable Asset Management
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