ROI-Market tightening gives central banks time to wait and watch: Mike Dolan

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

By Mike Dolan

LONDON, March 31 (Reuters) - Everyone has an opinion on what central banks should do with rates as the Iran war drives an energy shock. The answer, for now, may be nothing.

Most monetary authorities have so far only talked tough, warning of "decisive" action if needed. But a sharp tightening of overall financial conditions has already hit anyway, thanks to higher energy prices, rising borrowing rates, mortgage rates, wider credit premiums and falling stock prices.

The Chicago Federal Reserve's index of U.S. national financial conditions tightened in March by its most in any single month since U.S. President Donald Trump's sweeping tariff announcement last April - sending the gauge to its most restrictive since last May.

Prior to that, you have to go back to the regional banking jolt in March 2023 for a bigger monthly squeeze - and before that, to the Fed's last actual interest rate rise campaign in 2022 and 2023.

Goldman Sachs' equivalent U.S. measure chimed with the Chicago Fed version.

Its euro zone gauge also hit a 10-month high, though the March jump was less extreme than in America.

So why does that matter?

Central bank policy changes can be powerful, but only insofar as they change the real cost of borrowing for households and businesses.

If markets are already doing that job - through tighter loan costs, higher mortgage rates, energy-driven spending hits and lower stock prices - then the net effect of a central bank rate hike may already be playing out.

Since the February 28 U.S.-Israeli strikes on Iran, markets have priced out up to two expected Fed rate cuts this year. Real 10-year Treasury yields have risen more than 40 basis points, and 30-year fixed mortgage rates have jumped 40 bps to 6.4%.

Meanwhile, average regular unleaded gasoline pump prices have risen by a third and the S&P 500 has lost more than 7%.

Markets, in short, have tightened conditions as forcefully as any rate hike would have - which is precisely why the Fed's words have carried such weight.

At issue is how central banks communicate their thinking and how powerful that can be if the institution retains credibility with financial markets that ultimately transmit its decisions.

Fed Chair Jerome Powell made clear on March 18, echoing Mario Draghi's famous pledgeas ECB president: the Fed would do whatever it takes to deal with the oil spike.

"We're prepared to do what needs to be done," Powell said, while acknowledging nobody yet knows how long the oil shock will last.

ALL ROADS TO STAGFLATION

Powell's words, backed by colleagues' speeches, have been enough to take two more rate cuts out from market expectations and contributed to a tightening of financial conditions that many already felt were too loose, given an economy picking up steam with core inflation still a point above target.

The key point is the Fed has done nothing and markets now expect it to do nothing. And yet financial conditions have tightened significantly.

The risk is that markets eventually call the bluff, forcing the central bank to act. But that moment looks distant: long-run inflation expectations on both sides of the Atlantic remain close to their two-year averages.

As to what action should eventually be taken, if any, there's still a debate over the direction of the next move - whether the energy surge ultimately saps demand more than it lifts prices.

As International Monetary Fund economists opined on Monday: "All roads lead to higher prices and slower growth."

On that, strategists pore over prior examples of oil shocks - though none really maps exactly on to the current situation.

What's for sure is there is little comparison with the oil crises of the 1970s and '80s, given changes to energy efficiency, technology and wage bargaining even since. The shock from Russia's invasion of Ukraine in 2022 looms larger in European minds, but there are differences about policy settings back then too.

If anyone doubted there would be an inflationary pulse from the biggest monthly oil price hike ever, then Germany's March inflation data this week should put some of that to rest.

Headline German inflation jumped to 2.8% from just 2.0% in February, while European household inflation expectations almost doubled to their highest in four years.

And yet AXA Group's Chief Economist Gilles Moec points to the ECB's2011 "mistake" when it met rising oil prices and a tightening labor market with higher rates, which it was forced to reverse as the euro debt crisis erupted.

"What the ECB missed was the impact of rising long-term interest rates," Moec said - a lesson he thinks should weigh at least as heavily on policymakers today as the 2021-22 inflation surge.

What's more, the ability of central banks to guide markets to achieve their ends rests hugely on staying distant from political influence.

It's a significant testament to markets' enduring faith in Fed independence that they wiped out easing bets for the year - despite Trump-appointed Kevin Warshset to take the chair in May. Whether that faith is well placed or not will be a big focus of his congressional hearings next month.

(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)