The sharp rise in the price of oil following the outbreak of hostilities between Iran and the coalition of the United States and Israel presents central banks with the most unpleasant situation for them, a negative supply shock. By their action on interest rates, central banks influence the demand of an economy, the economic supply being considered as given and determined. In the present case, they are powerless to act against the drop in oil production.
On inflation, the rise in energy prices and a first round of almost mechanical second-round effects – for example for transport prices which are very correlated to energy prices for obvious reasons – cause the price index to jump, but what happens afterwards? This is the whole question for central banks.
If the inflationary dynamic does not change, the shock will just cause a bump in inflation, measured in variation over one year in prices, then it will return to its precise trend. In this case, the central bank has nothing to do. But if businesses and households revise their inflation expectations upwards for their price policy or their wage demands, the central bank will have to raise its rates.
Which raises the question of the impact on economic activity. If economic activity falls or slows down because of this shock, the transformation of this shock into a surge in inflation will be compromised. If activity continues, it will undoubtedly be more necessary to act to curb the second round effects. Markets are now pricing in several rate hikes in Europe, but the deterioration in surveys says we could be in the first scenario.
Julien-Pierre Nouen
Director of economic studies and diversified management, Lazard Freres Gestion
Julien-Pierre Nouen is director of economic studies and diversified management at Lazard Freres Gestion
