Investors expecting a US interest rate rise could be in for a surprise

The global energy shock triggered by the war in Iran has changed the calculus for central banks. The surge in oil and gas prices has driven up inflation. According to JPMorgan, the average headline inflation rate in developed economies increased from 2.2 per cent in January to 3.3 per cent in April.

Bond markets are concerned that central banks in advanced and emerging economies have fallen behind the curve. In a report on June 5, Bank of America said 46 of 68 central banks are currently overshooting their inflation target.

A growing number of central banks, particularly in Asia, have already raised borrowing costs or are signalling a tightening in policy, partly because of risks to financial stability that have been amplified by the energy crisis. Indonesia’s central bank has increased interest rates by three-quarters of a percentage point in less than two months in response to the sharp fall in the rupiah. India is under pressure to follow suit.

The four major central banks – the US Federal Reserve, the European Central Bank (ECB), the Bank of Japan (BOJ) and the Bank of England – have been more cautious so far. This is about to change. The ECB is widely expected to raise rates this month despite the precarious state of the euro-zone’s economy. The BOJ is also likely to increase borrowing costs when it meets on June 15-16 amid persistent yen weakness.

However, it is the outlook for US monetary policy that is far more consequential. Since May 22, the world’s most influential central bank has been headed by Kevin Warsh, whose dovish views convinced US President Donald Trump to appoint him Fed chair.

Although Warsh was a long-time inflation hawk, he called for lower borrowing costs mainly to help him win the nomination. He also wants the Fed to shrink its balance sheet and believes interest rate decisions should be based on a wider range of inflation data.