The energy shock for which there is no playbook

A preliminary deal signed 15 June to cease hostilities between the United States and Iran and reopen the Strait of Hormuz to oil and liquified natural gas shipments is good news, but not the end of the energy shock. Even if the Strait reopens seamlessly, supply chains, shipping, insurance, inventories and winter gas risks will take weeks if not months to normalise. For policymakers, the question is therefore shifting to how to manage the inflation, fiscal and trade consequences of a shock that may fade only slowly.

The standard policy response is for central banks to hold steady and not adjust interest rates in the face of higher energy prices, while governments provide fiscal support to cushion the blow to household incomes and firms’ balance sheets. For households, the Iran shock is felt as higher petrol, heating and food bills. For importing economies, it is higher prices paid to oil producers abroad.

But in the current context, governments in the European Union, US, United Kingdom and Japan must seek to offset the loss for those least able to bear it when higher prices are proving stubborn and fiscal positions are historically weak. In such circumstances, the standard response is almost certainly contradictory.

Even before the Iran shock, inflation had not yet returned cleanly to target after the COVID-19 pandemic and Russia’s invasion of Ukraine. Debt ratios are higher, long-term borrowing costs were already creeping up and the foreign central banks and reserve managers who once purchased government debt at almost any price are no longer doing so.

Against that backdrop, aggressive monetary tightening – interest rate hikes – would worsen debt dynamics. Expansive fiscal support worsens the inflation problem and drives borrowing costs higher. Doing nothing is no better: financing costs rise into a slowing economy while sharp currency depreciations feed back into the inflation spike.

In principle, there is a solution. Fiscal support should be targeted narrowly at the households and sectors most exposed, rather than the broad-based transfers of 2022 when energy prices spiked because of the conflict in Ukraine. Governments should not resort to shorter-term debt for funding. It looks cheaper today but concentrates the refinancing problem into the moment when the next shock hits. Long-term interest rates should be left alone, signalling what investors think about future inflation and policy.

Central bankers may need to do something they won’t like: step in to cap the rise in shorter and medium-term interest rates, so that the cost of government borrowing does not crowd out the targeted fiscal response. This should be accompanied by published exit rules explaining how and when such intervention will stop.

This option is not universally available. The credibility of central bank decision-making depends on initial conditions, institutional design and the market’s belief that the exit will be honoured. The United States has the most room for manoeuvre: it issues the world’s reserve currency and has deeper capital markets than any other economy.

The European Central Bank’s 25 basis point hike on 11 June crystallises the constraint. The tightening was done to keep price rises manageable, yet it also raises the cost of provision of fiscal support for the countries that can least afford it. Any conditional intervention by the ECB in their bond markets would revive fears that it is backstopping one sovereign over another: the fragmentation risk for which the ECB created a special bond-buying facility in 2022 (the Transmission Protection Instrument), and which has never fully gone away.

By contrast, Japan’s central bank can use its large foreign reserves to prevent the yen from weakening in a way that magnifies the energy inflation shock into domestic prices. The Bank of England has the least leeway: no large reserve buffer against currency weakness and an economy that depends on foreign financing, meaning higher rates may still be needed to defend sterling even as they make the domestic-debt and growth trade-off more painful.

The second phase in the response to the shock will begin when northern hemisphere winter heating demand layers onto an already-impaired supply chain, which will stay impaired regardless of the diplomatic track. European gas storage is at low levels; Qatar will need two to three months to restore capacity after any reopening of the Strait. A ceasefire does not end the energy bill in time for winter.

All in all, the policymakers most likely to need the toolkit also face the most constraining circumstances, while those who need it least are also less constrained. That is the wrong way round, and ordinary borrowers and savers in the most exposed economies will pay the difference.