The Role of Central Banks in Managing War-Driven Inflation

The economic consequences of warfare are as varied as they are complex.

by Faruk Imamovic
The Role of Central Banks in Managing War-Driven Inflation
© Getty Images/Chip Somodevilla

The economic consequences of warfare are as varied as they are complex. Traditionally, war is seen as an inflationary phenomenon. This is in stark contrast to the initial deflationary impact of the pandemic, which only turned inflationary in response to subsequent policies.

The early days of the COVID-19 outbreak in 2020 saw a rush towards the safety of bonds, a move that seemed logical given the uncertainty of the times. Fast forward to the second quarter of 2024, the landscape looks markedly different.

Ongoing shadow wars, border skirmishes, and limited conflicts continue to fuel high inflation expectations, complicating the Federal Reserve's mandate to manage economic stability without the accompanying panic that typically drives a flight to safer assets, like bonds.

Market Response to Geopolitical Events

Traders found themselves riveted to their screens as tensions flared between Israel and Iran, following explosions near military facilities in Isfahan, Iran. The situation, unfolding late at night New York time, was initially murky.

By morning, analyses had begun to coalesce around the notion that the strikes were a measured, retaliatory action by Israel. These were not attacks on Iran's nuclear capabilities but rather on a facility possibly linked to earlier drone attacks against Israel.

This precise and limited military engagement is indicative of a broader strategy of maintaining plausible deniability and keeping the conflict within the bounds of a shadow war, rather than escalating to full-scale warfare.

Despite the restrained nature of this strike, the markets reacted with nervousness reminiscent of the early days of the pandemic, with investors rushing to traditional safe havens such as U.S. Treasury bonds, gold, and currencies like the Japanese Yen and Swiss Franc.

This reaction underscores a fundamental difference between the market dynamics at play during health crises and those during military conflicts. While the latter tends to be inherently inflationary, the former can start as deflationary until governmental policies counteract those effects.

The Elusive Quest for Peace and Its Economic Implications

The ideal scenarios for bond investors would be either complete peace or total war—the former being disinflationary and the latter prompting a robust flight to safety in U.S.

Treasury bonds. However, the current reality of intermittent and limited conflicts leads to persistent high inflation and cautious central banks, conditions that are generally unfavorable for bonds. On a broader economic note, central bankers are again expressing concerns over currency volatility and inflation, signaling a potentially prolonged period of tight monetary policies.

In the United States, for example, Minneapolis Federal Reserve President Neel Kashkari has suggested that interest rate cuts might not be feasible until 2025. His counterpart in New York, John Williams, hinted at possible rate hikes if economic data justifies such a move.

Monetary Policy Amidst Geopolitical Tensions

As Europe continues grappling with inflation, there appears to be little chance for an immediate easing of policies, with European Central Bank officials suggesting that rate cuts might not occur until mid-June.

Similarly, in emerging markets, monetary normalization looks increasingly challenging, particularly if the U.S. Federal Reserve delays its easing cycle. This is further complicated by currency depreciation, which tends to stoke inflationary pressures.

The global financial landscape is thus at a crossroads, influenced by both geopolitical instability and economic policy decisions. While inflation might eventually subside in the U.S. due to factors like decreasing rent inflation and an overabundance of manufacturing capacity in China, the structural changes such as deglobalization, demographic shifts, and the impacts of climate change suggest a complex and possibly prolonged period of economic recalibration.

European Central Bank© Getty Images/Ralph Orlowski

Currency Dynamics and Potential Shifts

In the realm of currency markets, particularly notable is the status of the USD/JPY exchange rate. Japan, with its history of market interventions, faces unique challenges and opportunities in this volatile environment.

The Bank of Japan has managed to maintain its credibility without the need for drastic measures, such as significant policy rate increases or a sudden halt to government bond purchases. However, the current global climate, marked by escalating military tensions and economic policy shifts, suggests a potential reversal or at least a stabilization in the USD/JPY trend.

This scenario could see a move towards the downside, particularly if war escalations lead to further market jitters, as was observed recently. The overarching theme in these market reactions is the delicate balance between investor sentiment, driven by geopolitical events, and the strategic responses of central banks across the globe.

As investors and policymakers alike navigate these turbulent waters, the unpredictability of both conflict and response underscores the intricate dance of global finance.

The Role of Investors and Policymakers

In the face of ongoing geopolitical tensions and economic uncertainty, investors and policymakers must tread cautiously.

The immediate reaction to rush to safe-haven assets underscores the pervasive sense of insecurity that global conflicts can instigate. However, the lack of a full-scale crisis or a clear path to peace suggests a challenging road ahead for those seeking stability in both bonds and broader financial markets.

For policymakers, the task is equally daunting. The need to balance inflationary pressures with growth, to manage currency volatility while ensuring economic stability, requires a nuanced understanding of both economic principles and geopolitical dynamics.

Central banks, particularly in pivotal economies such as the U.S. and Europe, find themselves at the forefront of this challenge, tasked with making decisions that could have far-reaching consequences for global economic health.