Treasury
Global Energy Price Shock Complicates Central Banks' Policy Outlook, Says TD
The shock to global energy prices from the Iran war has complicated outlooks for central bank policy, said TD.Before the conflict, labor markets had cooled visibly, and an array of uncertainties weighed on demand, wrote the bank in a note to clients. But the shock to oil prices and global shipping has jerked inflation up once again.Now, energy prices are near-certain to remain elevated without any meaningful progress toward a resolution of the conflict that would allow transit through the Strait of Hormuz to return to pre-conflict levels, stated TD. This raises the likelihood that energy inflation spills over to broader categories of consumer goods.Such concerns were on full display during the string of central bank announcements at the end of April, pointed out TD. Forward guidance struck a hawkish tone as central banks marked their inflation forecasts higher for 2026 even as rates remained on hold.With gross domestic product growth running close to potential across advanced economies, the bank's view is that higher energy prices will leave a dent on demand, dampening the knock-on effects of the energy shock on broader goods and services.Market expectations for year-end policy rates have shifted accordingly, added TD. The Bank of Canada is now expected to conduct two hikes by the end of 2026, up from zero in February.The rate pricing for the European Central Bank, which was also widely anticipated to stay on hold this year before the Iran conflict, has jumped to three hikes as traders focus on the bloc's heavy reliance on imported energy. Expectations swung widest for the Bank of England, as markets moved from pricing in two cuts back in February to three full hikes.As for the Federal Reserve, rate cut expectations for this year have evaporated despite the impending confirmation of Kevin Warsh, a President Donald Trump appointee, as the new Fed chair, and hike pressures are now building.Policy rate expectations for the Bank of Japan have moved little since the onset of the Middle East conflict, though this is in part because rate hikes were already priced in and now the economic outlook is weaker. If anything, growing inflation pressures should allow for faster normalization of central bank policy in Japan.The current inflation shock is being driven first and foremost by energy costs, but the bigger risk is whether it starts to broaden into core goods, services and inflation expectations, noted TD. For now, headline inflation is uniformly higher across advanced economies, while core inflation remains contained in places like Canada, Japan and the eurozone, but is firmer in the U.S. and the United Kingdom.Amidst rising inflation expectations, central banks are expected to remain cautious even as softer demand limits the risk of a broad-based acceleration in core inflation. The policy backdrop has become more complicated, with elevated energy prices driving the hawkish narrative of markets, according to TD.
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