Amidst the ongoing Middle East conflict, disruptions to energy supply chains have meaningfully reshaped the global inflation and growth outlook, and in turn, expectations for central bank policy paths. Most central banks have since adopted a wait-and-see approach as the conflict’s macroeconomic impact gradually becomes clearer. Markets, however, have taken a more hawkish view on interest rates. Compared with the start of this year, market pricings have shifted from more than two rate cuts in the U.S. to a full rate hike by year-end, with a similar repricing across other major developed markets.

While inflation rates have moved back above target in most economies, and prolonged supply side disruptions are likely to continue uniformly exerting inflationary pressures globally, the key differentiator for monetary policy will likely be how each central bank balances upside inflation risks against downside risks to growth. And with wide differences in domestic economic conditions and central bank reaction functions, interest rate paths are likely to diverge further in the coming months.

Behind the (Fed)cade

For the U.S., headline activity data appears to point to a robust economy—economic growth remains on track near trend rate level, and a steady unemployment rate suggests a broadly balanced labor market. However, underlying dynamics have hinted at a more subdued and uneven picture. Recent growth has been mostly concentrated in fixed investments in business, particularly in equipment and intellectual property, driven by artificial intelligence (AI) upcycle-related spending. In contrast, real consumer spending growth has been relatively more modest, with mounting downside risks as higher energy prices gradually begin to erode households’ real disposable income.

The labor market also displays an unusual dynamic. Despite muted labor demand as reflected in below-average hiring rates and softer job growth, lower net foreign immigration has structurally constrained labor supply, mechanically limiting upward pressure on the unemployment rate. As a result, while the headline unemployment rate still runs marginally above the Fed’s long-run estimate—which typically bodes for a hawkish response during episodes of surging inflation—underlying labor market weakness likely sets a higher bar for rate hikes. Modest and decelerating wage growth, which has decoupled from the lower unemployment rate, further reinforces limited upside risks from a wage-led spiral into services inflation, and this may leave the Fed in no rush to adjust interest rates. 

Hawks circling in Europe

In the UK and Europe, however, monetary policies could become notably more hawkish ahead. While both economies are prone to downside risks—a weak labor market in the UK and stalling economic growth in the eurozone, both central banks have expressed similar concerns over de-anchoring inflation expectations and have signaled the possibility of adopting a pre-emptive, proactive stance toward tightening policy. For the ECB, the June staff projections have implicitly factored in a total of three rate hikes, and for the BoE, the April scenario analysis’s “medium” scenario indicates at least one rate hike ahead. Also, with limited signs of supply chains normalization in the near term, the likelihood of materializing these scenarios has correspondingly increased. While downside economic surprises would still be welcome, such as the recent services-led drop in UK inflation, which could delay the timing of the next rate hike, the overall policy outlook could remain hawkish absent any meaningful resolution in the Middle East. 

Policy divergence in Asia

Japan remains the key outlier within developed markets. Higher energy prices, combined with a persistently weak currency, have lifted imported inflation and should normally point to a similarly more hawkish policy outlook. However, the BoJ’s cautious reaction function and its asymmetric focus on growth over inflation have meant that external supply shocks may instead pose greater downside risks to domestic demand, clouding visibility on the underlying wage-led inflation trend, and thereby oppositely implying further delays to policy normalization. That said, while rate increases are likely to remain gradual in the near term, the risks of falling behind the curve have become more pronounced. With markets beginning to price in a higher terminal rate, this may prompt the BoJ to slowly accelerate its hiking schedule over the medium term, further diverging Japan’s monetary policy path from other developed markets.

Divergence is also apparent within the rest of Asia. Economies with larger oil inventories, lower fuel weights in consumer price index (CPI) baskets, stronger current accounts, and AI-led growth offsets, such as parts of North Asia, could likely wait out the shock for longer. In contrast, markets with higher reliance on energy imports, weaker fiscal buffers, or greater currency vulnerability could however face earlier monetary policy responses, as seen in Indonesia and the Philippines, where tightening has already begun. However, the more prudent and proactive stance in these economies should help limit spillover into the broader inflation basket and reduce the aggregate tightening required before interest rates peak. Currency weakness also adds another layer to a hawkish bias in the near term, as higher rates help stabilize capital flows, restore confidence in local currencies, and prevent further depreciation-led imported inflation. We expect Asian central banks to set monetary policies based on their own domestic circumstances, instead of just tracking the Fed or developed market central banks.

At any rate

Taken together, the key differentiators for monetary policy will remain differences in domestic economic conditions and central bank reaction functions, particularly in the balance each central bank strikes between inflation and growth risks. That said, uncertainty is likely to remain elevated in the near term, whether from known sources such as dynamics under a Warsh-led Federal Open Market Committee, or from unknown anomalies such as another geopolitics-led external shock. As such, while market repricing of forward rates and inflation expectations has remained largely front-loaded over the medium term over the next year, any additional pressure from more persistent inflation or structural shifts in reaction functions could point to sharp shifts in the rates market. Although this creates a more complex outlook that may be challenging for a static global duration view, this has turned more beneficial to a more proactive and selective approach to fixed income, with active duration becoming increasingly important. 

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