A week of central bank decisions

Today has some uncomfortable echoes of the 1970s. Back then, the 1973 Arab oil embargo and the 1979 Iranian Revolution sent energy prices soaring and pushed the US into stagflation. Growth stalled, inflation ran hot and the US Federal Reserve (Fed) struggled to get control of it. Arthur Burns, who chaired the Fed at the time, was widely seen as yielding to political pressure from President Nixon to keep interest rates low, with damaging consequences. 

Fast forward to today. The incoming Fed chair, likely Kevin Warsh pending Senate confirmation, faces a similar situation. President Trump is pushing hard for lower policy rates, while higher energy prices are again adding to inflationary pressures. Warsh has publicly stressed the Fed’s independence, but the real test will come from how he balances the central bank’s dual mandate: maximum employment and price stability. 

Start with inflation. Forward-looking indicators suggest price pressures could tick higher in the coming months, due to higher energy prices. The longer energy stays expensive, the more those costs filter through to other sectors, which could make inflation harder to control. At the same time, higher energy costs act like a tax on the economy. They slow activity and eventually dampen inflation through weaker growth.  

That leads to the second point: growth. Energy prices staying higher for longer is a headwind for overall growth, including job creation. Still, the US is starting from a position of strength. Going into the current geopolitical tensions, the economy was in a phase of economic exceptionalism. Recent data back that up. Retail sales in March have held up even as gasoline prices climbed. April purchasing managers’ indices (PMIs) raised odds that the economy’s resilience was holding up into the second quarter of this year. Investment tied to AI and government support, including tax cuts, continues to support the economy. 

Today’s inflation pressure is largely a supply-side shock, caused by the oil disruptions in the Middle East, which is difficult to fix with interest rates alone. Hiking rates does not produce more oil or cheaper energy. And lowering them while growth remains resilient would immediately raise questions about whether the Fed is acting independently or bending to political demands. 

Altogether, we think the Fed may deliver a quarter of a percentage point cut towards the end of 2026, though the precise timing remains uncertain. AI-driven productivity gains may ease inflation over time, while high energy prices could weigh on growth, which might ease inflationary pressures further down the line. But that is probably as far as the Fed can go. Deeper or faster cuts would risk seeing history repeating itself: being too accommodative and letting inflation regain momentum. Against the backdrop of large and widening fiscal deficits, this underpins our underweight position in US Treasuries. 

The US, Israel, Iran and Lebanon have all agreed to a temporary ceasefire. Yet markets stayed cautious. The reason is simple: underlying tensions between the US and Iran have not fundamentally eased and the Strait of Hormuz remains effectively shut.  

With oil prices pushing above USD 100 per barrel at the time of writing, risk assets were on a slightly weaker footing than the previous week, despite a fairly solid earnings season so far. Higher oil prices also pushed government bond yields higher across almost all the major markets. 

One area stood apart. Semiconductor stocks continued to rally. The Philadelphia Semiconductor Index continued to rise into unchartered territory, and the Nasdaq rose as well. The driver was guidance from large technology companies that came in well above expectations. Intel was a clear example, with sales projections that surprised to the upside. 

We still think the AI-driven rally has further room to run, which is one of the reasons why we remain invested in US equities. At the same time, we are mindful of the risks and hold a moderate overall equity overweight. Announced job cuts, such as those from Meta, suggest some firms are trying to offset surging capital expenditure. 

Japan’s latest inflation data showed prices still moving higher. Despite this backdrop, we expect the Bank of Japan to keep interest rates unchanged (Tuesday), given ongoing geopolitical uncertainty, while signalling that future rate increases are possible and, we think, rather likely. 

The Fed (Wednesday) is also likely hold policy rates and is unlikely to commit to a clear path in what will be the last meeting chaired by Jerome Powell. First-quarter economic growth (Thursday) should show a bounceback, partly driven by a rebound in government Expenditure post government shutdown in the final quarter of last year. 

Europe tells a different story. The latest PMI surveys point to clear weakness across the region. The Eurozone composite PMI, a key gauge of economic activity, fell below the 50 level, which marks the line between expansion and contraction. That move reinforces concerns that Europe is facing a classic stagflationary shock, with energy prices pushing costs higher as activity slows. Price components in the surveys are now rising at their fastest pace in three years.  

First-quarter economic growth figures and April inflation numbers will be closely watched before the European Central Bank (ECB) meets on Thursday. The ECB is expected to keep rates unchanged for now. Recent comments from policymakers suggest they want more evidence before deciding whether rates need to rise. We think an increase before year-end is still possible, but it will depend on whether inflation proves sticky even as growth weakens.  

In the UK, the Bank of England is also likely stay on hold at its meeting on Thursday. However, the odds of an increase in the Bank rate are somewhat higher than in continental Europe, as the UK PMIs were higher than expected and showed a clear improvement that contrasted with the softer trend seen across the euro area.