Contrary to typical FX reactions, hawkish ECB policy amid an energy shock would be profoundly negative for growth. Any rate hikes would compound the economic damage from higher energy prices, making the Euro more vulnerable.

Historical precedent is unequivocal: central banks do not cut interest rates in response to an oil shock. Despite the negative growth impact, their primary concern is preventing the initial price spike from embedding into long-term inflation expectations. Market hopes for easing are contrary to all historical data.

Current market pricing for ECB rate hikes is aggressive, similar to when oil was near $100. This is considered "borderline too high" as it overlooks how higher energy prices also introduce significant growth risks, creating a high bar for the ECB to deliver more than two additional hikes.

Markets pricing in ECB rate hikes after an energy shock is flawed. Higher energy prices are a negative growth impulse for Europe, hurting terms of trade and consumer spending. Hiking rates would only worsen the downturn, making European cyclicals and the Euro vulnerable regardless of policy.

During an energy supply shock, central banks are trapped. Hiking rates doesn't increase oil supply and often causes a recession, leading to a policy reversal within a year. Conversely, stimulating the economy fuels demand into a supply-constrained market, worsening inflation. There is no easy path forward.

Central banks typically ignore transient energy shocks without raising rates. However, because baseline inflation remained elevated for five years, an ongoing energy shock forced monetary authorities to hike rates instead of cutting them. This policy shift directly pushed short-term government bond yields up by more than a percentage point across advanced economies.

Single-mandate central banks like the ECB and BoE are trapped. They must react to oil-driven inflation with hawkish policy, even though their economies are most exposed to the energy shock's demand destruction, creating a stagflationary double whammy.

Policymakers, scarred by post-COVID inflation, risk tightening monetary policy excessively in response to energy price surges. History suggests these shocks are temporary and primarily affect headline, not core, inflation. The greater danger is stifling economic growth by overreacting to a transient inflationary impulse.

The Fed is treating war-driven energy inflation like a consumer spending problem. This flawed approach of hiking rates risks triggering a recession without addressing the root cause, as monetary policy can't solve geopolitical supply shocks.