CONTRIBUTORS
Michael Browne
Investment Strategist,
Franklin Templeton Institute
This week a client challenged me with the question: ‘Who would want to be a central banker?’
Just think of the complexities of the current situation in the Persian Gulf with the closure of the Strait of Hormuz, where within a narrow channel pass 25% of all vessels in the world carrying crude oil and 20% of those carrying liquefied natural gas. This follows the experience of inflation in 2022, when Russia’s invasion of Ukraine sent oil prices skyward at a time when supply lines had not yet fully recovered from the COVID-19 pandemic. Inflation peaked at 8% in the United States and 11% in the United Kingdom.
We will begin to hear some answers to these questions when, helpfully, the European Central Bank (ECB), the US Federal Reserve (Fed) and the Bank of England (BoE) meet later this week.
I will try to give a preview by presenting four different scenarios and what I think central banks will do in each one.
Scenario 1: The war ends by 17 March.
The price of oil per barrel would likely retreat below US$80 almost immediately. Banks would likely change language, become data-driven, and adopt a wait-and-see posture about interest-rate cuts. There would still likely be some inflation to come, but it should be limited and likely to recede. We would see virtually no impact on business and consumer confidence.
Scenario 2: The Strait of Hormuz remains closed until early- to mid-April.
Oil prices peak between US$100 and US$110 per barrel, and the price returns to US$80 in June. This creates real problems and probably different outcomes. The Fed, with its dual mandate and with interest-rate policy still tight, would probably look through the potential inflation increase and call it a blip. But the primary impact will already be clear, and there would be concerns about secondary effects. Fuel and some food prices, along with overall household bills, would likely rise. However, I think a language change may not be enough, and we may be more likely to see the removal, where appropriate, of any rate-cut language in the policy statements that follow the meetings. In the ECB and the BoE’s Monetary Policy Committee (MPC), there will probably be split votes. It is likely that business and consumer confidence will have weakened sharply, cutting demand and pausing capital expenditure. Politicians will have talked about intervention but done little. This is the scenario that is currently priced into markets.
Scenario 3: The Strait remains closed all the way through April but re-opens by the end of May.
The end of April is a critical time because it is when the next round of central bank meetings are scheduled. Oil prices would likely exceed US$120 during April, and at times rise near to US$140, with little relief in terms of declines. As in 2022, prices might not fall to US$80 until year-end. Inflation would become very evident across economies, and it would become probable for peaks between 6% and 10%, as in 2022. Bonds and equities would sell off further. Most worryingly, the whole yield curve would shift higher, and the market would price in interest-rate increases from most central banks except the Fed. Rates would likely rise in Europe: In this scenario, I see the ECB raising rates 0.25% and the MPC would do the same, citing precaution. Some members of both of these policy-setting boards may vote for a 50-basis-points (bps) increase. The hit to European consumer confidence could be heavy, and I believe household savings would rise yet again while businesses would react accordingly by cutting labour. Concerns about rising material prices would have impact on capital expenditure and infrastructure plans. Equity markets would be looking at the stagflation trade, with a strong US dollar further pushing up energy inflation outside the United States. Credit risks would rise.
Scenario 4: The Strait remains closed until the mid-June meetings and oil has been over US$150 per barrel.
Oil prices peak above US$150 per barrel, and in this scenario, there is little prospect of seeing prices below US$100 per barrel in 2026. While the Fed would probably try to look through interest-rate increases, it would find it hard to placate markets without them. In Europe, potential rate increases of 50-bps from both the ECB and England’s MPC would push rates to 2.75% and 4.50%, respectively. These banks could make explicit threats of further rate increases of 50 bps to ensure that they do not get caught out as in 2022. The yield curves flatten and perhaps invert in the United Kingdom. The relatively slow pace of action by the Fed in this scenario would weaken the US dollar. Earnings estimates for equities would turn negative as the full stagflation trade comes into place. Those economies that can subsidise domestic fuel prices may do so, but most country balance sheets would not be strong enough for such measures. Those countries with relatively low reliance on gas and oil, such as France, Norway and Switzerland, would see lower inflationary impulses, while those that are more dependant, such as the United Kingdom and Germany, would come under pressure. Credit risks would appear.
Clearly, as each of these scenarios are time-dependant, and the risks are skewed to the negative. In my view, central banks would do well to be aggressive in both word and deed as early as possible. The single mandate in Europe allows for little wiggle room, and the prospect of stagflation would rise. But the best policy might be to act in haste and regret at leisure. It will be what markets may do.
Parting shot
Last week, I spent a day meeting Members of Parliament (MPs) from all political parties. What was striking was the near unanimity of their assessment of problems facing voters—a sense that however hard you work, you get poorer every year. The MPs’ suggested remedies from party to party, though, could not be more different.
The key takeaway is that the economy—including the cost of living, the lack of growth and inflation—will be the central issue for the electorate for the rest of the decade. For the last decade, the economy had been below other issues such immigration and the National Health Service. This is a significant change.
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