The Iran war is trapping the world's central banks with an energy shock that simultaneously undermines growth and stokes inflation, with no good policy response to either.

• Each of the world's most important central banks faces that dilemma in policy meetings this week.

Why it matters: From Tokyo to Washington, central banks that were on track to normalize policy are now paralyzed, unsure whether the energy price shock will prove more consequential in causing sustained inflation or in sapping growth.

• The longer the war drags on, the more the global economy will have to grapple with a stagflationary problem that no interest rate decision can solve.​​​​​​​​​​​​​​​​
• The Bank of Japan was the first to deal with this dilemma earlier today, as it elected to leave rates steady. The Fed follows tomorrow, and the European Central Bank and Bank of England each meet on Thursday.

What they're saying: Like the BOJ, other central banks this week will "hold rates steady as they all face slightly different versions of the same dilemma," Karl Schamotta, chief market strategist at global payments firm Corpay, wrote in a note this morning.

• Namely, "whether the energy shock rippling through global markets will prove transitory or become embedded in prices, echoing the post-pandemic inflation surge."

Driving the news: The BOJ held its benchmark rate steady at 0.75% today. Before the war, central bank watchers had expected a rate increase — a continuation of the gradual tightening cycle that the BOJ began in March 2024, when it raised rates for the first time in 17 years as it escaped decades of deflation and negative borrowing costs.

• Three of nine board members dissented in favor of an immediate hike — a sign that some top officials believe that the inflation threat feels urgent enough that waiting carries its own risks.​​​​​​​​​​​​​​​​
• The bank slashed its 2026 growth forecast in half, to 0.5%, while raising its core inflation outlook 0.9 percentage point, to 2.8% — the arithmetic of a stagflation trap.

Zoom in: Japan is particularly exposed to Iran war fallout: It sources more than 90% of its crude oil from the Middle East, nearly all of it through the Strait of Hormuz, which remains effectively closed.

The big picture: In the context of several reoccurring shocks over the past six years, central banks are questioning whether war-related effects will scramble the usual playbooks.

• Japan could raise rates because energy costs and a weakening yen are forcing the bank's hand, not because the economy is chugging along and can digest higher borrowing costs.

"Our decision today is based on the view that central banks should look through temporary supply shock-driven inflation," BOJ governor Kazuo Ueda said at the press conference.

• "But if such shock brings about second-round effects on underlying inflation, we must raise interest rates," Ueda added.
• The central bank chief faces a complication familiar to his global counterparts: political pressure to hold off on hiking rates as Japanese Prime Minister Sanae Takaichi — an advocate of looser monetary policy — weighs fuel subsidies and other measures to cushion households from rising energy costs.

The bottom line: The BOJ expects to avoid a 1970s-style oil shock, but Ueda acknowledged an uncomfortable parallel: Rates are still below neutral, meaning the bank is already behind the curve if inflation takes hold.

It didn't get a ton of attention amid other urgent news, but a key official last week made a case for a significantly leaner Federal Reserve system.

Why it matters: In the vision laid out by Fed governor Christopher Waller — which aligns with the past views of incoming chair Kevin Warsh — the 12 Federal Reserve regional banks would centralize their back-office operations to become smaller, more focused institutions.

• It implies that each bank would be less of a self-managed island, with fewer employees devoted to operational matters.

State of play: Waller, who chairs the internal committee at the Board of Governors overseeing the reserve banks, laid out several areas of focus.

• That includes doing economic research, gathering information from contacts across their region and providing day-to-day supervision of banks.

Yes, but: "Now let's turn to a very different class of activities that are important to the System's overall operations and for which geography does not matter," Waller said at the Brookings Institution last week (the same day as Warsh's confirmation hearing, a reason for which even attentive Fed watchers can be forgiven if it fell through the cracks).

• "The list includes HR systems, payroll and benefits administration, finance and accounting, procurement, and vendor management, as well as the payments, IT, and fiscal agency work," he said.
• "These functions are not delivered better or more efficiently with geographic dispersion. Nor are they unique to a district. They improve with integration, scale, and standardization. With that comes lower operating costs, risk reduction, and greater savings for the American taxpayer."

Of note: In a 2023 interview, Warsh said that while he favors having Fed banks get perspectives from around the country, he would advocate changes that he called turning the regional banks into "centers of excellence."

• "There is very little reason for duplication of thinking, back offices or capabilities across the system," Warsh told New York University's Simon Bowmaker in an interview for his forthcoming book, "Fed Reckoning: Conversations on America's Central Bank." Bowmaker shared a transcript with Axios.
• "I think we would end up over time with a more robust deliberation if each of the Reserve Banks devoted its resources to areas in which they are uniquely well positioned," Warsh said.

By the numbers: The reserve banks employed a combined 19,000 people in 2024, per the Fed's latest annual report, ranging from 877 in Philadelphia to nearly 3,000 in New York.

• The banks incurred a cumulative $5.9 billion in operating expenses that year.
• Those costs don't directly constitute federal spending, but they're ultimately borne by taxpayers in that they reduce the Fed's remittances to the Treasury.