The Iran conflict has quickly moved monetary policymakers’ thoughts from how much policy easing is necessary to support growth to whether current policy settings are restrictive enough to absorb a prolonged energy shock without allowing inflation expectations to drift. Markets have reacted, and now we wait to see what policymakers will do. In this Insight, we quickly consider the position of the Federal Reserve, ECB and Bank of England following recent meetings.
The Federal Reserve held the federal funds target range at 3.50% to 3.75% in April, with the FOMC pointing to elevated uncertainty from developments in the Middle East and reiterating that it remains attentive to risks on both sides of its dual mandate. Inflation has moved higher, partly reflecting global energy prices, partly reflecting tariffs, while US activity remains sufficiently resilient, albeit driven mostly by AI infrastructure build-out, to give the Fed little reason to take policy risks. Chair Powell’s press conference described the current stance as appropriate for supporting maximum employment and returning inflation to target.
The voting split was illuminating. Stephen Miran dissented in favour of a 25-basis point cut, but Beth Hammack, Neel Kashkari and Lorie Logan supported the hold while objecting to language that still retained an easing bias. There remains a dovish tail on the Committee, but the centre of gravity has shifted towards guarding against inflation persistence. The March dot plot already suggested limited scope for lower rates, with the median projection for the federal funds rate at 3.4% at the end of 2026 and a growing cluster of participants expecting only one cut or no cuts this year.
For the Fed, the likely path is a prolonged hold unless the labour market weakens materially. While the US economy is better insulated than the UK or Europe to the impact of the war from an inflation and growth perspective, the underlying economy is softening. Higher oil and gas prices may feed into wages, service prices or inflation expectations, but the Fed is unlikely to enter tightening mode.
The ECB also held rates in April, leaving the deposit facility rate at 2.00%, the main refinancing rate at 2.15% and the marginal lending rate at 2.40%. The statement was explicit that upside risks to inflation and downside risks to growth have intensified. The euro area entered the shock with inflation closer to target than the UK or US, but also with much lower interest rates, notwithstanding the fragile growth backdrop, and a heavy reliance on wholesale gas. The policy trade-off is therefore stark: raising rates could worsen weak activity, but looking through the shock too readily risks validating a second inflation episode.
Unlike the FOMC, the ECB is probably close to a reluctant hike in rates. While financial markets have tightened in a similar manner to the UK, looser monetary policy and the rapid rise in energy prices mean that pre-emptive tightening is more likely. The ECB historically has a lower tolerance for inflation. ECB policymakers have started to talk up the chances of a near-term rise and investors are betting heavily on it being at the next meeting, but uncertainty around the length of the war continues to play on decision-making. However, the longer it continues, the longer it will take for normality to resume, and this point will be key for the ECB.
The Bank of England is in an unenviable position, but the rapid market response and already restrictive monetary policy have given the MPC a little leeway. The MPC voted 8-1 to maintain Bank Rate at 3.75% in April, with hawkish Huw Pill voting to increase it to 4.00%. The uncertain outlook, in which traditional forecasting tools tend to break down, led the Bank to move away from a single forecast and present three scenarios in the April Monetary Policy Report, which reflected the uncertainty around energy prices, demand and second-round effects. The focus on second-round effects was key, particularly after the experience following the start of the Ukraine war.
Scenario A, with a shorter-lived energy shock and limited second-round effects, supports holding Bank Rate before considering lower rates later. Scenario B is more awkward, implying a longer period of restrictive policy, whereas Scenario C is the adverse case: persistent energy price pressure, stronger pass-through, higher inflation expectations and a need for forceful tightening. Pill’s dissent and some other members’ views show that scenario C is viewed as a real possibility, requiring immediate action.
The UK is already experiencing above-target inflation, albeit driven more by government policy than consumer-led demand. The underlying economic environment is soft, and the labour market has loosened, and both are likely to weaken further; there is little in common with the post-Ukraine war situation. While household and business inflation expectations have picked up, there is uncertainty over whether businesses can make higher prices stick. The seeming reluctance of the more hawkish MPC members (except Pill) to vote for tighter policy two meetings into the war suggests that the Bank may use expectations/the market to manage policy rather than taking any overt action themselves. However, this will change should signs of embedded inflation surface.
The Iran war is both inflationary and growth-negative. It raises headline inflation through energy and food costs, squeezes household incomes, increases business costs and damages confidence. Central banks can usually look through first-round energy effects, but they cannot ignore persistence, particularly after the recent bout of high inflation. The test is whether businesses and workers treat the shock as temporary or build it into pricing and wage-setting, but this will take some time before becoming evident in the data.
The policy conclusion differs for each central bank. The Federal Reserve can hold because the economy is unlikely to experience the severe effects on either side faced by Europe or the UK. The ECB may need to tighten its much looser policy to head off a rise in inflation expectations for which it has no tolerance, despite economic damage. The more restrictive policy level of the Bank of England allows it to hold for now, but building second round effects will see a definite response. Across all three, future policy is now conditional on inflation persistence. A move towards looser policy in the future will require strong evidence that the energy shock is fading, inflation expectations remain anchored and second-round effects are contained.
Arlingclose assists clients with treasury risk strategy amid volatile economic and market conditions. For more information, please get in touch with nkeeling@arlingclose.com.
08/05/2026
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