Superficially, the Middle East energy crisis appears to be the type of external shock that central banks should downplay. However, growing evidence suggests the current situation may differ significantly. The conflict involving the US, Israel, and Iran that erupted on February 28 has driven Brent crude prices up approximately 50% to $108.50 per barrel, raising risks of a global inflation surge.
In theory, central banks should avoid policy changes based on such events unless it's clear the impact will be persistent or will durably raise inflation expectations. The Bank for International Settlements (BIS)—an organization promoting financial stability among central banks—has urged policymakers not to act hastily, describing the current crisis as a textbook case for downplaying supply shocks.
Yet central banks appear unlikely to follow this advice. They remain sensitive to criticism following the 2022 Russia-Ukraine conflict—whether fair or not—when they were perceived as acting too slowly by mistakenly labeling high inflation as "transitory," only to see inflation remain above target for years.
Furthermore, the notion that inflation expectations in developed markets are "firmly anchored"—a long-held belief among central bankers—now appears questionable. Recent years have witnessed a series of black swan events that could structurally elevate inflation expectations, potentially triggering a wage-price spiral.
The COVID-19 pandemic—theoretically a once-in-a-century shock—first disrupted supply chains alongside stimulus-driven demand surges, causing significant price increases. This was compounded by global energy market disruptions from the Russia-Ukraine conflict. Now, the Middle East conflict adds another shock layer.
Against this backdrop, the global trade system that suppressed inflation for decades has been disrupted by tariff wars initiated by former US President Donald Trump. Combining these factors, policymakers appear unlikely to remain passive indefinitely—regardless of whether this represents sound policy.
The Bank of England, Federal Reserve, and European Central Bank all maintained interest rates at recent policy meetings. Yet there's little indication they will downplay the current energy crisis. Their communications instead suggest the opposite intention.
Fed Chair Powell stated last month, "We're very aware of how inflation has behaved over the past few years, and how a series of shocks has interrupted the progress we've made over time." The BOE's March 19 policy minutes warned that "after recent successive negative supply shocks, households and businesses may exhibit greater sensitivity to any new inflation shock."
The ECB echoed the same day: "If high energy prices persist, they could lead to broader inflation through indirect and second-round effects, requiring close monitoring." Unless the Strait of Hormuz—a critical global energy artery currently affected by Iran—reopens fully soon, central banks may feel compelled to act.
However, recent history should give policymakers pause. BOE Monetary Policy Committee external member Alan Taylor recently discussed a thought experiment examining what would have happened if central bankers had focused solely on returning inflation to target since 2020, without considering growth implications.
In this scenario, UK interest rates would have exceeded 10% in 2023 (versus the actual 5.25% peak) and would remain around 7% today, triggering a severe recession... while inflation would still reach 7%. This represents just one scenario, but current conditions warrant caution for other reasons.
First, the starting point for interest rates differs completely from the post-pandemic period. Then, rates were near zero; now, the Fed's policy rate stands at 3.5-3.75%, the BOE's at 3.75%. Both indicate they consider their rates somewhat restrictive. The ECB has signaled readiness to raise its 2% key rate to address rising inflation risks.
The lesson from the post-pandemic inflation surge isn't necessarily to act faster, but to communicate better. Mistakes were indeed made, particularly in insisting price jumps were "transitory," but central banks have clearly adopted greater caution in current projections.
Both the ECB and BOE have introduced scenario analyses showing how economies might evolve under different conditions. In February's annual stress test scenarios, the Fed's baseline projected 2.2% inflation, versus just 1.0% under its severe adverse scenario (typically modeling recession from demand shock). Current testing would likely yield significantly different results.
The ECB's baseline forecasts 2.0% inflation next year, 2.1% under adverse conditions, and 4.8% under severe conditions. Only the latter signals need for rate hikes. The BOE will release corresponding projections in late April.
If supported by firm commitments to achieve inflation targets medium-term (though not immediately), these scenario analyses might help anchor expectations without requiring immediate policy adjustments. Policymakers should also guard against overreacting to credibility concerns.
By responding more flexibly to current conditions—rather than attempting to compensate for past errors—policymakers could actually enhance their credibility. Regarding the BOE, National Institute of Economic and Social Research Director David Aikman recently noted: "Credibility isn't demonstrated by mechanically reacting to data beyond central bank control, but by clarifying what central banks can control, what they're monitoring, and what actions they'll take if conditions worsen."
Ultimately, if central bankers focus on fighting the "last war" rather than addressing the realities of the "current war," they risk facing accusations of repeating significant policy errors.
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