Oil and energy shocks in the first half of the year presented central bankers with another stern test of their willingness to ensure price stability.
The traditional central banking playbook, which recommends that policymakers look through initial commodity-based shocks that temporarily boost inflation, was not used by the European Central Bank, Bank of Japan and Reserve Bank of Australia, all of which lifted rates.
But the Federal Reserve, People’s Bank of China, Reserve Bank of India, Bank of Canada and Bank of England all held rates steady, preferring to see how events played out.
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With a ceasefire in place in the Middle East, albeit imperfect, and oil having fallen back to prewar price levels, the playbook remains intact and top-line inflation can be expected to ease.
This new period should provide a tailwind to the global economy and allow central banks to return to more domestic-oriented concerns. Major central banks, as a result, will most likely remain on hold.
But rates are still at a higher level than before the pandemic as a regime change in inflation and interest rates takes hold around the world.
If anything, rates are poised to go even higher as competition for scarce global capital heats up.
The Japanese yen, for example, will fall as investors turn away from government-issued debt in favor of private-sector investments around artificial intelligence.
Global central bankers will face a balancing act as they prioritize price stability while remaining cautious about lifting rates as the global economy in general and the Asian economies in particular recover from those first half supply shocks.
Despite mild stagflationary risks across the G-7 economies, we do not anticipate any further rate hikes by the large global central banks at this time.
Federal Reserve
With oil prices easing back toward prewar levels and the prospect of a supply glut returning to the forefront of global investor concerns, we expect the Federal Reserve to keep its policy rate between 3.5% and 3.75% for the remainder of the year.
The bond market appears to be looking through the threat of long-term inflation, pricing in just a bit more than a single Fed rate hike.
This should result in the U.S. 10-year yield to continue trading in a range between 4.4% and 4.6%. We think that the front end of the yield curve should ease back toward 3.75% to 4% and that the long end of the curve at the 30-year maturity spectrum will trade near 4.8% to 5%. As a result, the dollar will become mildly weaker by the end of 2026.
Regime change is the focus at the Fed where Kevin Warsh, as the new chair, is in the process of reducing forward guidance for global investors.
That change will in turn lead to more volatility and result in market-based estimations of the Fed’s reaction function—the estimation of the optimal policy rate—which represents a clean break from the past generation of American central bankers.
In addition, following the ECB summer policy conference it is clear that global central bankers are slowly backing away from attempting to smooth volatility through communications policy.
That new approach will place more emphasis on market-based indicators and institutional-based estimations of the impact of policy, rates and inflation.
European Central Bank
The European Central Bank hiked its policy rate by 25 basis points in June, lifting the deposit rate to 2.40%, and we think that will be it for now despite market expectations of at least one more rate cut this year.
While it is unusual for central banks to raise or reduce its policy rate once and then refrain from further moves, the war in Iran and the oil shock have made for unusual times. We do not see another rate hike in July. But if inflation continues to accelerate, any rate increase can wait until the September meeting at the earliest.
The ECB is on the record as pointing to risk around persistent inflationary pressures from the first half supply shocks. Given recent pricing dynamics, we are not convinced.
In our estimation, energy prices are likely to provide sufficient policy space for the ECB to hold off on hiking its policy rate further.
Should a supply glut form in global oil markets and refined product production in the Persian Gulf normalize more quickly than expected, then we would anticipate that no rate hike in the second half will become the baseline forecast.
Bank of Japan
The Bank of Japan hiked its policy rate by 25 basis points to 1% at its June meeting, which is the highest level since 1995. Its next meeting is on July 31, by which time we expect inflation concerns to have eased. But a mild speculative attack by global investors that reduced the yen to its lowest level since the 1980s will keep pressure on the Bank of Japan to hike its rate to defend the currency.
The effective halting of Japanese government bond purchases by the central bank should on the margin continue to ease volatility at the long end of the curve.
But it is clear that global investors intend to test the willingness of the monetary authorities to protect the yen, which may at one point require the Bank of Japan to act sooner than it would otherwise prefer to hike its policy rate.
While the overnight index swaps suggest one more rate hike this year, should the yen remain under pressure that may set the table for further rate hikes early in 2027.
Bank of England
We expect that the Bank of England will talk like a hawk and walk like a dove in the second half of the year. Investors are of the same mind and have yet to price in a full rate hike this year.
That is because oil and energy price dynamics will provide a much-needed assist to the Bank of England that is warily watching an economy that persistently underperforms amid a changing political environment.
The Bank of England held rates steady at its June meeting and we expect the policy committee to communicate its willingness to act quickly to curb any risk to price stability in the near term.
But it will proceed cautiously with any rate increase given the sharp drop in oil prices and the political uncertainty as it awaits its next prime minister.
Bank of Canada
Persistent weakness in household consumption, investment and growth, and volatility in the labor market all require the Bank of Canada to maintain a dovish outlook.
At its policy meeting on June 15, the Bank of Canada indicated that it saw limited evidence that higher energy prices were being passed through to consumers. We expect the central bank to take no action at its next meeting on July 15 as it reassesses its underlying dovish outlook on rates.
We do not see any rate hikes for the rest of the year. Market participants tend to agree and at this time there is neither a rate cut nor a rate hike priced in for the rest of the year.
But because of persistent economic weakness, if oil prices fall more than expected we would not be surprised if the Bank of Canada starts signaling a potential rate cut.
Reserve Bank of Australia
The Reserve Bank of Australia is in a holding pattern with a tightening bias, not an easing cycle.
At its meeting on June 16, the Monetary Policy Board left the cash rate unchanged at 4.35% after three increases since the start of the year. The committee judged that tighter financial conditions were beginning to slow the economy but that inflation remained too high.
The central bank’s message was one of caution: leaving rates on hold does not rule out further tightening if inflation expectations or second-round price effects become embedded.
“Higher for longer” is therefore the dominant near-term policy frame. The Reserve Bank of Australia is unlikely to ease while trimmed mean inflation remains above target and while energy-related price shocks are still passing through.
The central bank’s May statement was conditioned on market pricing for the cash rate rising toward 4.70% by the end of the year, although the June pause shows the Monetary Policy Board wants to assess lagged effects before moving again.
The real challenge for policymakers is managing an economy that is barely gaining momentum, while inflation remains sticky and the labor market only gradually turns.
People’s Bank of China
The People’s Bank of China will sustain its easing bias over the near to medium term as it cautiously observes the next policy decision out of the Federal Reserve.
Given that the consumer market remains extraordinarily soft with households reluctant to spend, a rate cut of 10 basis points in the second half of the year makes sense.
For 13 months, commercial banks have kept lending rates unchanged. Given the relatively soft position of the domestic economy, we see no reason why that should change. Strong exports and solid AI-led investment will continue to support the overall economy.
While there are tentative signs of stabilization in housing prices in some major markets, the major policy challenge in China remains the deflation in domestic housing and residential commercial sectors.
This requires fiscal and monetary accommodation and is why we think a cut in the policy rate during the second half of the year makes sense.
Reserve Bank of India
The Reserve Bank of India will cautiously watch the evolution of energy prices as a global El
Nino condition likely reduces crop yields, sending up food prices which will most likely result in a 6% inflation rate this year.
That will in turn keep the RBI’s repo rate on hold at 5.25% through the October policy meeting as the central bank assesses how the balance between falling energy costs and rising food prices results in higher inflation.
For now, we think that results in the start of a modest rate hike cycle at the December meeting. Should oil prices fall below $60 per barrel then the central bank may wait until early next year to start a rate hike cycle.
