The hawks are back

One of the more important messages from recent central-bank communication is that policymakers are becoming more hawkish again in response to the inflation risks linked to the war in Iran. As Bloomberg reports, the ECB is now openly discussing the possibility of rate hikes should higher energy prices start to feed into second-round effects and push inflation materially above target.

That risk is real. But if the main inflation threat comes from imported energy prices, the economy may unfortunately do part of the central bank’s job on its own. Higher oil and energy costs act like a tax on consumers: disposable income falls, consumption weakens, and broader demand softens. Add to this the knock-on effect of higher goods prices caused by more expensive energy and transport, and the result is not only an inflation shock, but also a rising recession risk.

That is why, at this stage, we are actually more concerned about growth than about inflation. A severe energy shock can of course lift headline inflation sharply, but it can just as easily undermine activity and confidence enough to slow the economy materially.

That said, as we wrote previously, we do not believe this is the most likely scenario for now. Our base case remains that the Iran situation will eventually calm down, as the belligerents themselves have little interest in a prolonged conflict with broader economic consequences. We therefore stay vigilant, but not yet convinced that markets are facing a lasting inflation regime shift.