ROI-How the Fed and other central banks can bark without biting: Mike Dolan

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Mike Dolan

LONDON, March 17 (Reuters) - The world's big central banks will want to pack at least a credible threat of higher interest rates this week to head off any inflation fallout from an oil price shock. If it's done well, they may not even need to pull the trigger.

This is a peculiar moment for central banks. The Federal Reserve, European Central Bank, Bank of Japan and Bank of England meet in the same week for the first time in more than four years, and there's no consensus on how to react to this month's Iran war-related oil shock.

Policymakers are trapped between two competing historical narratives.

One lesson from the oil and inflation shocks of the 1970s and 1980s was that it forced central banks to re-establish greater credibility in their willingness to stamp on inflation over time. And once they regained this, it then eventually allowed them to "see through" subsequent temporary oil-price spikes and focus on the economic hit instead.

The other lesson is from the pandemic reboot and Ukraine-related energy surge four years ago - when central banks were criticised for not acting quickly enough to tamp down elevated inflation. They then had to scramble to tighten rapidly after Russia's invasion of Ukraine compounded a post-COVID-19 inflation hump they were trying to "see through."

Each of the "Big Four" central banks is in a different space and each has its own domestic oddities to deal with.

But this week's unusual guidance from their global forum, the Bank for International Settlements, was to view an inflation jump from this oil price surge as again transitory - a word used by central bankers in 2021 to describe the post-COVID inflation pop, and one regretted since.

"If it's a supply shock, and certainly if it's a temporary one, these are the textbook examples where you should look through and not react with monetary policy," BIS' retiring top economic adviser Hyun Song Shin said on the release of the BIS quarterly report.

That advice marks a significant shift from the BIS tone only 18 months ago.

'WALLOPED' WORKERS?

In late 2024, BIS Deputy General Manager Andrea Maechler insisted central banks needed to be more "forceful" and active in responding to supply shocks in future and be careful in looking through them.

"Raising policy interest rates in response to adverse supply shocks may have only limited effects on activity if Phillips curves are steep," she said, referring to situations when there's a tight relationship between wages and unemployment.

"Then, slowing the economy to tame inflation could be less costly in terms of output."

The idea is that if central banks move earlier to pre-empt so-called second-round effects from supply shocks - which come via business margin padding or higher wage deals - then they would do less damage to the economy over time.

In other words, more policy rate volatility in the short term may be a price worth paying for longer-term rate stability and calmer inflation expectations.

But, as Maechler pointed out back then, that presupposes a steep Phillips curve tightly linking pay growth to job vacancies and available workers - an issue in post-COVID 2022 no doubt, but much less of an issue today.

TS Lombard economist Dario Perkins insists those labor shortages are gone. There's no momentum in employment, artificial-intelligence job fears are rife and workers don't have a cushion of post-COVID savings.

"This is not a situation that warrants monetary tightening, especially as rates are already a lot higher than in 2022," Perkins wrote. "To put it bluntly, central banks don't need to get tough and wallop workers - they are going to get walloped anyway."

U.S. President Donald Trump goes one further, calling on Monday for an emergency meeting to cut rates.

SHIFTING JUST ONE 'DOT'

But there may be a way of acting tough without hiking rates.

The Fed is the prime example.

With markets previously priced for at least two more rate cuts this year prior to the Iran attacks, all the Fed needs to do to act tough is signal no rate cuts at all.

The Fed's meeting this week was never really expected to deliver a rate move. But it is due to update its crucial summary of economic projections (SEP) that include inflation and policy rate forecasts from its officials - the so-called "dots."

As SGH Macro's Tim Duy points out, the inflation picture prior to the oil shock was already deteriorating. The Fed's favored personal consumption expenditures (PCE) gauge has now picked up considerable steam over the past three months - especially underlying rates excluding energy and food prices.

Duy reckons 3% "core" PCE inflation is likely a "red line" for the Fed. As it was already 3.1% in January and probably even higher in February, it may force the median Fed projection for 2026 overall higher too - especially in light of the oil shock.

"Even the bottom end of reasonable inflation forecasts should be sufficient to raise the median rate forecast to 'no cuts' in 2026," Duy wrote, adding that it would take only a move of one dot forecast to achieve that outcome for the median.

And, intriguingly, outgoing and embattled Fed Chair Jerome Powell could himself effect that outcome.

Shifting to a "no cut in 2026" stance in the dot plot, even as markets still price one, would let the Fed tighten without moving rates or resorting to nuanced, ambiguous language -and it can be walked back in three months if the Iran shock and inflation fade.

(The opinions expressed here are those of Mike Dolan, a columnist for Reuters.) Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source for global financial commentary. Follow ROI on LinkedIn, and X. And listen to the Morning Bid daily podcast on Apple, Spotify, or the Reuters app. Subscribe to hear Reuters journalists discuss the biggest news in markets and finance seven days a week.

(by Mike Dolan; Editing by Marguerita Choy)