Pain at the Pump Should Mean Pain in the Economy, Not Higher Rates

Traders are pricing in four more rate rises from the Bank of England than just before the war. Henry Nicholls/AFP/Getty Images Central banks live in fear of their last mistake. As the U.S.-Israeli war on Iran leads to higher inflation, investors are betting policymakers will do what they should have done in 2021: raise rates or at the least drop planned cuts. But there's a fundamental difference between the new oil shock and the postpandemic boom. Inflation today, already visible in rising prices at the pumps, is driven by restricted supply as Iran cuts off oil and other shipping through the Strait of Hormuz. The 2021-22 inflation was driven by soaring demand as stimulus-rich consumers emerged from enforced hibernation during Covid lockdowns. Central banks know how to deal with too much demand. They should have raised rates much earlier than their eventual 2022 rises to hold back borrowing and spending. Today, they can't do anything about the hit to supply, because, as the saying goes, you can't print oil. Yet traders are pricing almost three quarter-point rate rises by the European Central Bank this year. In the U.S. they expect rates to be flat, rather than the three cuts by the Federal Reserve previously priced in. And the Bank of England is priced for four more rises than just before the war. To me this makes no sense, for three reasons: History, the hit to the economy from expensive oil and the bigger threat posed to Europe than the U.S. First, history. In the annals of central-bank mistakes, three loom large: 1973, 2008 and 2011. In the oil shock of 1973-74 caused by the Arab oil embargo, the Federal Reserve is generally regarded as having ignored the second-round effects of oil prices and kept monetary policy too easy. But the mistake was made not when oil prices rose, but when they fell back during the deep recession caused by the oil-price spike. As recession took hold, the Fed eased policy, then kept it easy even when core inflation refused to drop below 6%. It's hard for those who weren't there to believe now, but in 2008 and 2011 the ECB raised rates, focusing on soaring crude prices and ignoring already obvious trouble in the financial sector. In 2008, it had to reverse course rapidly as banks imploded, and again in 2011 as the entire euro system threatened to implode. In each case, the problem of high oil prices quickly turned into a problem of a weak economy, with lower oil prices and falling inflation. As the saying goes in commodities markets, the cure for high prices is high prices. These hurt demand and, eventually, stimulate investment in new supply. Second, high oil prices also hit the economy. Consumers and businesses face higher and hard-to-avoid costs, much like a new tax. There should be no need for a double whammy for borrowers in the form of higher interest rates. The argument for higher rates is to avoid higher inflation becoming embedded in consumer and business expectations. This can lead to higher wage demands and an additional round of higher prices. But this is only likely if workers and businesses have bargaining power -- that is, if jobs are plentiful and consumers are eager to spend. Right now the labor market is strong, as the latest hiring report showed. But that's before the effects of higher oil sink in. Workers who can see few employers willing to hire are unlikely to threaten to quit unless paid more. Consumers worried about losing their jobs will borrow and spend less. Companies faced with weaker demand won't be able to raise prices so easily. Early signs are that consumers understand the problem. In the Michigan sentiment survey last month, those surveyed before the war started were much more positive about the economy, and expected much less inflation, than those surveyed afterward. Both groups also expect more near-term inflation, but far less long-run inflation. Even those asked during the war expect less long-run inflation than after the tariffs last April. Investors understand it, too. In the next year they expect much more inflation. But the bond market's best guess of inflation for the five years starting in five years is flat since the war began. A hit to supply reduces growth, and in the long term that means less inflationary pressure. This brings us to the third point, that in spite of this investors expect a series of ECB and Bank of England rate rises, while the U.S. stands pat. If anything, it should be the other way round. The U.S. is a net exporter of energy, so gets economic benefits from higher oil prices (though probably not enough to offset the pain for consumers of oil). Europe and the U.K. are big importers, paying more for their oil and so, in principle, suffering a bigger hit to their economies. That bigger hit should mean Europe and the U.K. have less need to raise rates than the Fed, not more. There are important caveats. Markets aren't as dumb as they sometimes seem, and there are two good reasons for tighter central-bank policy, or in the Fed's case dropping plans to ease. Psychologically, central bankers might feel they have to be seen to do something as inflation surges again. It isn't a good look for a central bank that dropped the ball in 2021 to cut rates just as inflation takes off again. Economically, it's possible to tell a story of U.S. growth that powers through higher oil prices, but it's a stretch. Those spending big on data centers to power the artificial-intelligence boom have already shown they don't much care about soaring costs for vital parts such as chips and generators. They might not be put off by higher oil prices, either. Wealthier consumers might keep spending the profits they've made from the stock market, too. That could support the economy even as drivers struggle with pump prices. Still, I find it hard to believe that the economy won't be hurt by oil-price rises that are significant enough to generate scary levels of inflation. As a result I like 2-year Treasurys at 4%, as they were in late March, and if 10-year U.K. gilts hit 5% again I like those even more.