Hiking Into a Supply Shock: What Central Banks Are Getting Wrong

Are We in a New Rate-Hiking Cycle?

Are central banks around the world raising interest rates again? If so, why — and are they doing the right thing? Let's look at what's happening in light of tomorrow's meeting of the Bank of England's Monetary Policy Committee (MPC).

It looks like we're at the start of a new hiking cycle. Since the start of the war in Iran, inflation expectations have risen, and prices themselves are now starting to climb again too. Under the orthodox, dominant monetary policy doctrine, the response to inflation is always the same: raise interest rates — regardless of whether the inflation comes from excess demand, a wage-price spiral, or a supply shock (such as the closure of the Strait of Hormuz). As a recent book on the subject put it, "if all you have is a hammer, everything looks like a nail."

Graph produced by Claude Code

A New Cycle Begins?

Last week, the European Central Bank raised rates by 25 basis points (0.25 percentage points) to 2.5%, the second hike of the year. As the central bank put it in its press release:

"The conflict in the Middle East continues to generate inflation pressures, and inflation is set to remain well above target for an extended period."

The ECB is now projecting inflation to stay above its 2% target through 2027, only converging to target, on average, in 2028. Markets have read this hawkishly, and are currently pricing in another hike from Frankfurt before year-end.

Today, the Federal Open Market Committee (FOMC) meets in Washington, and a rate hike is widely expected, given new Fed Chair Kevin Warsh's recent hawkish remarks and his renewed commitment to the 2% inflation target.

Tomorrow, September 17, it's the Bank of England's turn. The MPC is also expected to raise rates.

What Does the Inflation Data Actually Show?

What does the UK data tell us? Today, the 16th, the Office for National Statistics (ONS) released the latest inflation figures. In August 2026, headline inflation is up 3.3% year-on-year (compared with August 2025). The biggest contributor is transport, which makes up about 11% of the headline basket and rose 4.6% year-on-year and 1.5% month-on-month. Unsurprisingly, the main driver here is petrol and diesel — which account for around 2% of the headline figure but rose 23% compared with August 2025.

Producer price inflation, meanwhile, rose 6.1%. Once again, petroleum is the culprit. As the ONS itself noted in its release:

"Inputs of other produced material, which include refined petroleum products, provided the largest contribution to the rise in the annual inflation rate for input prices in August 2026, with prices increasing by 2.1% on the month."

In other words, the data suggests the war in Iran is finally feeding through into the inflation figures via higher energy prices. The Bank of England itself seems to acknowledge this. On September 8, Governor Andrew Bailey and two MPC members appeared before the Treasury Committee, where the geopolitical situation dominated the discussion. Bailey pointed to the widening "crack spread" — the gap between crude oil and refined-product prices — noting that Ukrainian strikes on Russian refining capacity have been a significant factor behind it. Deputy Governor Sir Dave Ramsden added that refinery maintenance, which firms had been postponing given the conflict, can only be deferred for so long — meaning the pressure on refined-product prices is likely to persist, and potentially worsen, the longer the war continues.

So it seems fairly clear to everyone that the current pickup in inflation is supply-driven — caused not by economic factors, but by geopolitical ones. Professor Alan Taylor said at the same Treasury Committee hearing that, absent geopolitical factors, the reasonable assumption is that inflation "would have been at target."

And this may well be just the beginning of a larger global shock, for two reasons. First, there's no end in sight to the war, and — as Bailey himself noted in the hearing — November may mark the end of emergency stock releases (it isn't clear whether he meant this globally or just for the UK). So, this shock may not be temporary at all. Second, oil and diesel prices feed into the cost of many other goods and services. For example, the trucks that carry food to supermarkets run on petrol, and the tractors working the farms run on diesel. As input costs rise, producers can either absorb them into their margins or pass them on to consumers.

Are Central Banks Taking the Right Decisions?

Despite their own understanding of the issue, central banks seem to have embarked on their anti-inflationary crusade once again. They must be hoping to destroy enough demand to offset the rise in supply costs.

But since geopolitical factors are entirely outside central banks' control, the likely result is that we all end up paying more for petrol, flights, and groceries — while some people lose their jobs on top of it. It's a fairly bleak, stagflationary outlook.

James Galgbrait claims that rising rates is “is pointless and counterproductive ”, and suggest that it is better to do nothing (no hike).  Even monetary economists who are typically hawkish on inflation, like Daniel Lacalle, have pushed back. As he put it on Twitter/X:

"Today's price destroys consumers' purchasing power and feeds headline inflation, while showing rate hikes would do nothing and are counterproductive."

He continued:

"If disruption remains, we get high prices and demand destruction."

Others, like Claudia Sahm, have argued that raising rates is the costly medicine — in terms of borrowing costs and a weaker labour market — that we need to limit price increases, because it is "the tool the Fed has to contain inflation." Nevertheless, if you only have a hammer…

Perhaps it's time to start rethinking monetary policy doctrine when it comes to supply-side shocks.