The central banks’ dilemma

• Enguerrand Artaz
  Strategist
  La Financière de l’Échiquier (LFDE)

This fear is all the more acute given that the last genuine episode of global stagflation, in the 1970s, had its roots in conflicts in the Middle East: the Yom Kippur War during the first oil crisis and the Iranian Revolution during the second. Whilst it is premature to use this terminology at this stage, it nonetheless captures the current mood: the fear of economic growth slowing and inflation rising again. This is a particularly tricky environment for central banks to navigate, many of which held their monetary policy meetings last week.

From the US Federal Reserve to the European Central Bank, via the Bank of England and the Bank of Japan, the assessment is unanimous. The conflict in Iran is reshuffling the economic deck and generating very high short-term uncertainty. Its consequences will depend on its duration and on potential escalations. The result: central banks have revised upwards their inflation forecasts for 2026 and 2027, with a much more pronounced impact on headline inflation – which includes energy prices – than on core inflation. This suggests that, at this stage, central bankers anticipate little pass-through of rising oil and gas prices to other goods and services. This stance is logical. Unlike in 2022, the current economic situation is far less likely to trigger an inflationary spiral, and significantly more prone to the risk of weaker growth.

From this observation, outlooks diverge. On the ECB side, growth forecasts have been revised downwards for the next two years. Growth is projected to fall to 0.9% for 2026 and as low as 0.4% in a ‘severe’ scenario. In this scenario, however, core inflation would rise to 3.9% in 2027, drastically limiting the institution’s capacity to support the economy. Unless it wishes to repeat the damaging mistakes of 2008 and 2011¹, the ECB has little reason to raise its rates in the near term, contrary to market expectations. But the central bank risks being just as powerless to support a European economy whose tentative recovery could be nipped in the bud by energy costs.

Whilst the Fed has, for its part, revised its growth forecasts upwards for 2026 and the following two years, it is not in a more comfortable position. It still anticipates a rate cut this year, but this prospect is widely called into question by core inflation, now forecast at 2.7% by the end of 2026. Nevertheless, the Federal Reserve is under significant pressure to ease its monetary policy, primarily from the White House, but also from the economy itself, due to weak employment figures. With 92,000 jobs lost in February – a figure likely inflated by strikes in the healthcare sector and by the weather – and a manufacturing sector that has itself shed 266,000 jobs over the past 12 months, the US labour market remains likely to experience a much sharper contraction in the coming months. The Fed thus finds itself caught between its two mandates, with little compelling evidence to tip the balance one way or the other.

The current inaction of central banks, whilst seemingly forced, is nevertheless probably the best response. Whilst the risk of recession stemming from this energy shock seems fairly obvious, the memory of the wave of inflation in 2022–2023 is still too vivid for central bankers to ignore. Above all, as the Bank for International Settlements’ chairman has pointed out, central banks are not supposed to use their monetary policy tools to respond to temporary supply-shock- . This is a lesson that the ECB, in particular, would do well to learn, given how costly its monetary policy errors during the Trichet era proved to be for the eurozone economy.

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¹On three occasions – in July 2008, and then in April and July 2011 – the ECB, under the leadership of Jean-Claude Trichet, raised interest rates against a backdrop of rising oil prices, at a time when the economic climate was particularly fragile.