Monetary Policy: Iran War and Inflation

Montary Policy Expectations of US FED

Federal Reserve Chair Jerome Powell said the Fed’s response to the US‑Israel–Iran War will depend on how the conflict affects Americans’ inflation expectations. He suggested the Fed may look through the current energy-driven supply shock and hold rates steady in the short term, but warned that persistent higher inflation expectations or a prolonged conflict could force tighter policy. The war has pushed oil and commodity prices up, dented consumer sentiment, and complicated the Fed’s tradeoff between managing inflation and a fragile labor market.

Federal Reserve Chair Jerome Powell recently told Harvard students the Fed is inclined to hold interest rates steady for now and look past a recent energy-driven price shock from the war involving Iran, arguing such supply shocks are usually transitory and monetary policy works with a lag. He warned, though, that five years of above-target inflation make it harder to assume the public will shrug off another bout of higher prices—if people and businesses start expecting higher inflation, policy choices become more difficult. The Fed faces a trade-off between fighting inflation and cushioning growth; recent developments raise the bar for any rate cuts this year. Powell also noted he will stay as “chair pro tempore” until a successor is confirmed; Kevin Warsh is President Trump’s nominee and faces a contentious confirmation.

In addition, New York Fed President John Williams said the Iran war has already added uncertainty and pushed some prices higher, particularly energy, and could raise inflation in coming months. He and Fed Chair Jerome Powell signalled the central bank can wait to see how these shocks affect the economy before changing its 3.50–3.75% policy rate. So far there is no evidence the conflict has raised long-term inflation expectations, though risks from oil, fertilizer and supply disruptions remain. Labor-market cooling has eased but stabilized, giving the Fed time to assess whether cuts are appropriate later. Key points:

• Powell favors holding rates steady for now and treating the energy shock as likely temporary but emphasized uncertainty about its economic effects.
• Fed officials (Williams and Powell) prefer to wait and observe effects rather than immediately change the 3.50–3.75% policy rate.
• Persistent above-target inflation risks changing public inflation expectations, complicating Fed policy.
• The Fed must weigh fighting inflation versus supporting growth; tools that help one may hurt the other.
• Recent comments from Fed officials signal a higher bar for future rate cuts—cuts are unlikely unless labor weakens or inflation falls.
• No current sign that the conflict has raised long-term inflation expectations, but supply shocks could still create inflationary pressure.
• Labor-market easing has stabilized since last summer, allowing the Fed some flexibility in timing potential rate cuts.
• Powell remains acting chair until a successor is confirmed; Kevin Warsh’s nomination faces political opposition.

Monetary Policy Expectations for Eurozone ECB

European central banks face pressure to raise interest rates after energy prices jumped following U.S./Israeli strikes on Iran, but officials are divided. Some policymakers warn rate hikes may be needed soon; others urge caution and want to see whether higher energy costs trigger sustained wage gains (“second‑round effects”) before tightening. The ultimate response depends on the shock’s size and duration, labor‑market dynamics, and whether households and firms pass on higher energy costs. ECB and BOE meetings at the end of April will be watched for clues. Key points:

• Eurozone inflation rose to 2.5% in March (from 1.9% in February), reflecting higher energy prices.
• Central banks will act only if higher energy costs lead to broader, persistent wage and price increases; they may hold if the shock is judged temporary.
• Past mistakes (ECB responses in 2011 and 2022) make officials cautious about overreacting to supply shocks.
• Current labor‑market conditions are less tight than in 2022, reducing immediate pressure for big pay rises; AI concerns may also temper wage demands.
• ECB and BOE meetings on April 30 are key near‑term checkpoints for policy direction.

Bank of England Future Policy

The Bank of England’s recent hawkish rhetoric shook the gilt market and pushed up rate expectations, but this seems like a deliberate “Maradona Effect” feint—meant to convince markets rates will rise while the BoE ultimately avoids actual hikes because weakening demand and the fiscal consequences would outweigh any inflationary impulse.

In short, the BoE’s hawkish messaging moved markets (10-year gilt yields ~5%), pricing in multiple hikes, but may be strategic signaling rather than a commitment to raise. If businesses and households expect higher rates, spending and wage demands fall, which itself reduces inflationary pressure—exactly the intended effect of the feint.

Implications of rising rates would worsen the government’s fiscal position (weaker growth, lower receipts, higher borrowing costs), limiting Chancellor Reeves’s ability to expand support. Incoming data (consumer and business confidence, spending) are likely to show demand weakening, giving the BoE cover not to raise rates.

Forecast: the base case: a short-lived window of attractive short-term UK interest-rate positions for investors; only a prolonged external shock (e.g., extended conflict) would force a different path.

UK mortgage approvals rose for the first time in five months in February, suggesting a tentative pickup in housing demand, but the widening Middle East conflict has rattled markets and pushed mortgage rates sharply higher, risking a renewed cooling of the housing market. Key points:

• Mortgage approvals: Lenders approved 62,584 mortgages in February, up from 60,246 in January (Bank of England data).
• Mortgage rates jump: Average two-year fixed rates rose from 4.83% at the start of March to 5.77%, the highest since August 2024; five-year fixed rates also increased.
• Market drivers: Lenders pulled deals and raised rates after the Middle East conflict prompted investors to reassess Bank of England rate-cut expectations and price in possible hikes.
• Broader lending: Unsecured lending increased by £1.9bn, driven by “other loans and advances” (personal loans, car finance); credit-card borrowing edged up.

Bank of Japan: Inflation and Monetary Policy

Japan’s companies remain optimistic about the economy despite pressure from rising costs, expecting consumer prices to increase by 2.6% over the next year. This optimism and persistent inflation expectations keep the Bank of Japan’s option to raise interest rates on the table.

Key points:

• Firms in Japan are upbeat about economic conditions even as they face cost pressures.
• Businesses expect overall prices (inflation) to rise about 2.6% over the coming year.
• Persistent inflation expectations mean the central bank may consider further rate hikes.

Their optimistic tone is informed by a mix of factors. Domestic demand has held up better than some forecasters predicted, helped by a resilient labor market and steady wage gains in certain sectors. Exporters are benefiting from pockets of global demand, particularly in high-tech and specialized manufacturing, while service industries are recovering as tourism and business travel increase. However, companies also cite several risks that could derail the recovery or push inflation higher than anticipated.

Risks and downside concerns:

• Supply-chain disruptions: Although many bottlenecks have eased, firms warn that renewed disruptions—stemming from geopolitical tensions, natural disasters, or outbreaks of disease—could quickly raise production costs and delay deliveries.
• Energy and commodity prices: Volatility in oil and raw materials markets can feed through to input costs. Businesses remain sensitive to sudden spikes that would squeeze margins or force more aggressive price pass-through to consumers.
• Global demand uncertainty: A slowdown in major trading partners would hit exporters and could undercut domestic confidence and investment plans.
• Wage-cost dynamics: While rising wages support consumption, they can also entrench inflation if productivity gains do not keep pace, prompting businesses to either raise prices further or absorb costs and cut investment.

Policy implications: The Bank of Japan (BoJ) faces a delicate balancing act. On one hand, encouraging firms’ and households’ inflation expectations toward a sustained 2% could help normalize monetary policy without destabilizing markets. On the other, tightening too quickly risks stalling economic momentum—especially in sectors still recovering from pandemic-era losses. The BoJ will likely monitor incoming data on wages, production, and consumer spending closely, signaling any shifts cautiously to avoid spooking markets.

Corporate responses: Many companies report passing at least part of their higher input costs onto consumers, but the extent varies by industry and product. Consumer goods with few substitutes and strong brand loyalty see easier price increases, whereas highly competitive sectors absorb more costs or pursue productivity measures such as automation and supply-chain diversification. Investment intentions are mixed: some firms plan to boost capital spending to enhance efficiency, while others remain conservative until demand steadies.

Outlook: If firms’ inflation expectations prove well-anchored and wage growth continues to support household incomes, Japan could see a gradual move toward more normal monetary policy settings without a sharp economic downturn. But the path remains narrow: shocks to energy prices, global trade, or confidence could prompt the BoJ to delay tightening or even consider loosening again. For now, businesses’ upbeat outlook and the 2.6% inflation expectation keep the door open for policymakers to act if needed, while underscoring the importance of close monitoring and flexible responses.