We just don’t know
This was a central bank “tour de force” kind of week, with considerable divergence in reactions to the Iran war from the various monetary policy makers around the world. We would characterize the Fed as slightly hawkish in its assessment of impact from the Iran war…but anything else would have been truly surprising. The median dot still indicates one rate cut this year, but seven FOMC participants see none (three see three or more). Notably, none currently sees reasons to hike. We see none, either. In fact, we side with the minority as we are reluctant to let go of our three rate cut forecast for the year—even as the market has moved violently in the other direction, pricing a slight probability of a hike.
To entirely forgo additional rate cuts this year seems very premature. The rationale evidently is the inflationary effect of the Iran conflict. But a prolonged conflict would present not merely an inflationary shock but also a material growth shock. With the labor market already leaning towards softness and with the potential for AI-labor disruption likely to intensify over the course of the year, we still see soft labor demand as the bigger concern. Higher interest rates would do nothing to stem inflation triggered by an energy supply shock, but could further dent labor demand and push unemployment higher.
There is no doubt that headline inflation will jump in March, but we have no way of knowing how soon and how fully that rise will be retraced. If the Iran conflict winds down with only moderate damage to energy production capacity within the next 5 weeks, there is plenty of time for normalization in activity. We are, after all, only in March. The lessons of Liberation Day should be remembered, namely, that worst case scenarios need not become reality, and that there is perhaps more resilience in the global economic system than we might dare to believe.