Central banks prepare for a long war

The maritime situation in the Strait of Hormuz is decidedly murky. Over the past 24 hours, the US and Iran have traded claims and counterclaims about the flow of ships through the waterway and whether hostilities had resumed. All the while, stocks of crude oil and refined fuels are dwindling.

This is causing volatility in energy prices. The European crude oil price swung wildly on Wednesday and Thursday (see below for an explainer). In the US, gasoline prices pushed higher even as crude did not. In an ominous development for President Donald Trump, the average US price of a gallon of gasoline jumped more than 30 cents in a week to hit $4.46. It was $3 per gallon before he attacked Iran. This was the difficult backdrop for the monetary policy meetings last week, at which the one common theme was that central banks are settling in for a long and unpleasant war.

The other conflict that looks as if it will run long is that between Jay Powell and the Trump administration. The outgoing US Federal Reserve chair announced he would stay on as a Fed governor until the investigation into the central bank was “well and truly over, with transparency and finality”. Just to ram the point home, he made it clear to the administration who was in charge of his departure: “I will leave when I think it’s appropriate to do so,” he said.

An embarrassment of BoE riches

The Bank of England maintained its interest rate on Thursday at 3.75 per cent, in what governor Andrew Bailey said was an “active hold”. This naturally raised the question of how a passive hold would look, but there was no doubt the BoE put a lot of work into its decision and wanted to show the world.

BoE staff produced 18 separate forecasts in total that highlighted uncertainty pretty effectively. But such was the embarrassment of riches that I saw many analysts and media colleagues misinterpreting the central bank’s charts. The main mistake was to suggest it had indicated rate rises were needed in all of its scenarios.

This was not true. I hope the following is a more understandable synthesis of the BoE’s thinking.

First, the BoE ditched its central forecast, which was a sensible move given the uncertainty over energy prices. The central bank resisted the temptation to plough on with its traditional methods when they made no sense. When it previously produced the central forecast, energy markets suggested a rapid return to normal but interest rate futures were pricing a long war.

Second, it produced three illustrative scenarios for oil and gas prices. Each assumed different “second-round effects”, from companies exploiting their pricing power to workers demanding higher wages.

Scenario A assumed oil and gas prices fell back quickly, following the current optimistic path of futures prices. There were no second-round effects. Scenario B was similar, but assumed energy prices would fall back more gradually and that modest second-round effects would elevate inflation. Scenario C was extreme, with energy prices rising significantly and inflation persistently high as firms and workers resisted declines in profit margins and real incomes respectively.

Third, the BoE ran these scenarios through its model using the assumption of market interest rates, which rise from 3.75 per cent to a little over 4 per cent. The results in all scenarios showed inflation rising, but returning durably to the 2 per cent target in scenario B. B was therefore chosen to be roughly consistent with market interest rate expectations. The inflation forecast was too low in A and much too high in C.

The problem here, however, was that the interest rate conditioning path was inconsistent with the energy price scenario in A and C. But as we all know, there is room for genuine disagreement on the right interest rate response in any scenario.

So the fourth decision taken by the BoE was to look at the possible evolution of interest rates in each scenario on the basis of five broad policy rules. That meant there were six variants of each scenario.

In all 18 published results, the path of interest rates was higher than the BoE forecast in February. But that did not mean they all implied interest rates would rise from the current 3.75 per cent level (as the chart below shows). The market-implied path is drawn in black.

Broadly speaking, scenario A means lower interest rates than both today and the market path. Scenario B is broadly consistent with the market path, but if the BoE wants to look through inflation (in line with the forward-looking Taylor rule) rates will be lower, and if it is worried about the salience of headline inflation (in line with the contemporary Taylor rule on headline inflation) they will be higher. Scenario C requires significantly higher interest rates.

When you average these rate paths across the three-year forecasting horizon, the various policy rules suggest interest rates in scenario A and B will be roughly on hold or move by about a quarter-point, while rising much more forcefully in scenario C.

The world will not exactly resemble any of these. We are currently in scenario A. Many on the BoE’s Monetary Policy Committee think scenario B is more likely, but were not willing to raise interest rates immediately. And if the stand-off in the Gulf continues, rate-setters cannot rule out scenario C, in which interest rates rise sharply.

The Fed is a prisoner

To understand the Fed’s monetary stance, the worst place to start is the Federal Open Market Committee statement setting out the central bank’s policy. It is an anodyne set of paragraphs outlining the Fed’s mandate, desire to be data-dependent and commitment to “adjust the stance of monetary policy as appropriate”. Any reasonable English interpretation of the words would suggest there was also no bias to raise or lower interest rates. Yet that didn’t prevent three members of the committee from voting against the statement, arguing the words contained an easing bias.

This is as absurd as the period at the European Central Bank under Jean-Claude Trichet, when if he uttered the words “strong vigilence” it meant the central bank would raise rates in the following meeting.

The press conference showed the FOMC increasingly thinks an easing bias is inappropriate. But Powell said the majority did not want to change the statement because it sends a signal and “you want to make [changes to it] in a way that will be sustained and continue to make sense”.

By definition, a change in the Fed statement to reflect that the risks are two-sided would be sustainable and make sense, whatever the central bank does next. So the FOMC’s nervousness about modifying it demonstrates the Fed is a prisoner of its own language. That’s not a happy place. But it leaves a quick win for Trump’s pick for Fed chair Kevin Warsh.

The ECB should be more flashy

The ECB acknowledged the world was “moving away” from the relatively benign baseline scenario in which it would keep interest rates on hold at 2 per cent. It looks set to raise rates at its June meeting unless the outlook improves.

Alongside these expected comments, ECB president Christine Lagarde berated anyone who used the term “stagflation” to describe the current stagflationary energy shock. Oh no, I’ve done it.

The term stagflation was “flashy”, Lagarde said, and could only be used to describe the 1970s when inflation was high, growth low and unemployment a big problem. “It’s a completely different situation,” she added. The chart below confirms inflation was higher in the 1970s. Growth, of course, was also higher.

What I’ve been reading and watching

• Read US economics editor Claire Jones’ answers to a barrage of questions about the Fed.

• It is always important to remember that because the US taxes road fuels less than other advanced economies, rising wholesale prices generate much larger retail price rises.

• Japan intervenes to defend the yen again.

One last chart

I learned something new last week. Data providers disagreed about what was happening to Brent crude oil prices on Thursday, just as the BoE and ECB were releasing their rate decisions and the oil price was gyrating. The reason is that April 30 was the last trading day for the Brent crude June benchmark. To derive a time series, some providers shifted to the July benchmark on April 30. The FT shifted on May 1. Others shifted the entire time series to the July contract, rewriting history.

Normally, structural breaks or the rewriting of history does not matter. But it does when futures prices are well below current prices, as they are now. I have charted the issue below for full transparency. I do not think there is a “correct” way of doing this. But it is always good to know how your data is constructed before you use it.

Central Banks is edited by Harvey Nriapia