No more "watering down"! Global central banks refuse to repeat mistakes, fearing a "heavy-handed approach" in the energy crisis.

Noticeably, at first glance, the Middle East energy crisis seems to be the type of external shock that central banks should "downplay." But more and more reasons indicate that this time may be different. The US-Israel war that broke out on February 28 has caused Brent crude oil prices to rise by about 50%, reaching $108.50 per barrel, increasing the risk of global inflation skyrocketing. In theory, central banks should avoid changing policies in response to events like this unless it is clear that the event will continue to exist or will push inflation expectations higher in the long term. The Bank for International Settlements (BIS) - an organization dedicated to promoting financial stability among central banks around the world - has urged policymakers not to rush into action, calling the current crisis a textbook case of a shock that should be "downplayed." However, central banks around the world may not heed this advice. They still remember the criticism (fair or not) they faced after the Russia-Ukraine conflict in 2022 - when they acted too slowly and wrongly labeled high inflation as "temporary," only to see inflation remain above target levels for years. Furthermore, the idea of "firmly anchored" inflation expectations in developed markets - a viewpoint that central bank governors have long reiterated - is now being called into question. In recent years, the world has witnessed a series of "black swan" events that could lead to a structural increase in inflation expectations, triggering a spiral of rising prices and increased wage demands. First, the COVID-19 pandemic - a once-in-a-century shock - led to supply chain disruptions and a surge in demand driven by stimulus policies, causing prices to soar. This was followed by the global energy shock triggered by the Russia-Ukraine conflict. And now, that conflict has been compounded by a new shock: the Middle East war. In this backdrop, the globalization trade system that has been suppressing inflation for decades has been disrupted by the tariff wars of former US President Donald Trump. With all these factors combined, policymakers seem unable to turn a blind eye for the long term - whether or not this is a wise move. Reasons for Caution The Bank of England, the Federal Reserve, and the European Central Bank have all maintained interest rates at recent policy meetings. But there is little indication that they will "downplay" the current energy crisis. On the contrary, their communications seem to convey the opposite message. Federal Reserve Chairman Jerome Powell said last month, "We are well aware of how inflation has behaved in recent years and how a series of shocks has interrupted the progress we have made over time." The minutes of the Bank of England's policy meeting on March 19 warned, "Households and businesses may be more sensitive to any new inflation shocks after suffering a series of negative supply shocks recently." The European Central Bank also stated on the same day, "If high energy prices persist, they could lead to broader inflation growth through indirect and second-round effects, a situation that needs to be closely monitored." Unless the global energy artery - the Strait of Hormuz - blocked by Iran opens fully again soon, central banks may feel compelled to take action. But recent history should make policymakers pause to think. Alan Taylor, an external member of the Bank of England's Monetary Policy Committee, recently discussed a thought experiment he and his colleagues conducted to explore how central bank governors would act if they focused solely on bringing inflation back to target from 2020 onwards, without considering the knock-on effects on growth. In his scenario, UK rates would exceed 10% in 2023 (instead of the actual peak of 5.25%) and remain around 7% today, leading to a severe economic recession... with inflation still reaching 7%. This is just one scenario, but for various other reasons, the current situation also warrants caution. First, the starting point for interest rates now is drastically different from post-pandemic levels. Rates were close to zero then, while now the Federal Reserve's policy rate is at 3.5-3.75%, and the Bank of England's is at 3.75%. Both have indicated they believe their rates have some constrictive impact. The European Central Bank has already signaled readiness to raise its 2% key rate to address the rising inflation risk. Wait and Communicate The lesson from the post-pandemic era of soaring inflation may not be that action needs to be faster, but that communication needs to be better. There were indeed mistakes, particularly in persisting that price spikes were "temporary," but central banks seem to be more cautious in their projections this time. The European Central Bank and the Bank of England have both introduced scenario analyses, showing how the economy could change under different conditions. In its stress-test scenarios published in February, the Federal Reserve predicts inflation at 2.2% under its baseline, and only 1.0% in its severe adverse scenario (typically simulating a recession caused by demand shocks). If these tests were conducted now, the data would likely be very different. The European Central Bank's baseline forecast predicts inflation at 2.0% next year, 2.1% in the adverse scenario, and 4.8% in the severe scenario. Only the latter signals a need for rate hikes. The Bank of England will release its corresponding forecasts at the end of April. Supported by firm commitments (not immediate, but towards achieving the inflation target in the medium term), these scenario analyses could help anchor inflation expectations without central bank governors rapidly resorting to policy levers. They should also be wary of an overreaction due to concerns about credibility. By being more flexible in responding to the current situation - as opposed to trying to rectify past mistakes - policymakers can actually enhance their reliability. Regarding the Bank of England, David Eichmann, Director of the National Institute of Economic and Social Research (NIESR), recently stated, "Credibility is not established by mechanically reacting to data beyond the central bank's control, but by demonstrating clearly what the central bank can control, what it is paying attention to, and what actions it will take if the situation worsens." Ultimately, if central bank governors focus on winning the "last war" rather than addressing the realities of the "current war," they may face accusations of making significant policy errors once again.