The 2026 Hormuz crisis has surfaced a structural shift in central bank reaction functions — specifically, a visible re-prioritization of energy-driven inflation over the standard underlying-inflation / wage-growth inputs that dominated pre-2026 Taylor-rule thinking. Both the ECB and (per JPM) the Fed are now tilting policy toward offsetting the second-round effects of energy inflation, even when underlying inflation and wages remain subdued.

Definition

A central bank's "reaction function" is the policy rule — formal or informal — that maps incoming macro data into policy rate decisions. The classical reaction function weighs:

  1. Headline / underlying inflation gap from target
  2. Wage growth and labor-market tightness
  3. Output gap and growth surprises
  4. Inflation expectations (often as a forward-looking supplement)

The energy-shock reaction function observed in 2026 weights these inputs differently: energy price inflation becomes the dominant variable, with second-round effects into headline and expectations prioritized even when underlying ex-energy inflation and wage growth are subdued. This is a deliberate or instinctive departure from the "look through transitory supply shocks" reaction function that prevailed pre-2022.

Evidence

The shift is documented in the September 11 institutional cluster:

  • 2026-09-11-ecb-rate-decision-september-2026: On September 11, 2026 the ECB delivered its second Hormuz-shock rate hike, taking the deposit rate to 2.50% (from 2.25%). The decision was a "unanimous no-brainer" per Lagarde. Markets priced 88bp more tightening with peak reached September 2027. The critical analytical signal comes from Danske Bank / FXStreet: "Lagarde mainly focused on energy prices and gave very few comments on developments in underlying inflation and wages... As the ECB reacts more to energy developments than underlying inflation compared to our previous expectations of their reaction function, we revise up our policy rate forecast." ECB baseline ex-energy/food inflation is already above target (2.5% 2026, 2.6% 2027), but the energy component alone (14.3% y-o-y in August) is the binding input.
  • 2026-09-11-jpmorgan-kaneva-forever-war: JPM derivatives strategy team explicitly notes the US analog: "Long-term U.S. rates are higher, but they may simply reflect a shift in the Fed's reaction function: policymakers entered 2026 expecting several cuts and now appear to be leaning toward hikes." Fed Chair nominee Warsh's August 28 Jackson Hole speech (referenced but not ingested this batch) is the public trigger for this shift.
  • inflation-transmission-channel: The Chatham House (May 2026) framework that energy shocks are inflationary, second-round effects are real, and central banks face a "very unpleasant challenge" — rate hikes cannot make oil go down but must prevent second-round effects.

Mechanism

Three factors explain why the reaction function has shifted:

  1. Second-round risk is now empirically validated. The 2022 Russia energy shock showed that what looked transitory became structurally embedded in wages, services prices, and expectations within 18-24 months. Central banks now treat energy inflation as a credible second-round risk, not a benign supply blip.
  2. Crisis persistence. Six months into the Hormuz war (per 2026-08-24-csis-iran-war-six-months), the energy shock is no longer "transitory" — duration has overtaken scale as the binding constraint (cf. duration-dominates-scale). "Look through" frameworks assume short duration; a 6-month-and-counting shock breaks that assumption.
  3. Refined products now drive the shock (refined-products-as-shock-center). Because diesel is the upstream input to trucking, freight, agriculture, and military logistics, the inflation transmission is direct into wages and food prices rather than diffuse. The reaction function responds to the intensity of transmission, not just the headline number.

Counter-arguments and Limits

  • Underlying inflation may still bind. ECB baseline ex-energy/food is 2.5-2.6%, already above target. If wages re-anchor higher (a 2022-2023 pattern), the energy-shock reaction function could collide with a wage-driven reaction function — creating an unintended tightening cascade.
  • Growth constraint. ECB raised 2026 growth to 0.9% (resilient) but kept downside risks. A 2027 recession triggered by the rate hikes themselves would force a reversion. JPM's "Forever Conflict" scenario at $87 Brent 2027 implicitly assumes the reaction function does NOT ease even with persistent elevated prices.
  • Fed divergence risk. The Fed (per JPM) is "leaning toward hikes" but Powell-to-Warsh transition introduces uncertainty. If the Fed eases while ECB hikes, EUR strength compresses European growth asymmetrically.
  • Political pressure. The ECB faces domestic political pressure (e.g., German manufacturing) to ease. Lagarde's hawkish stance is institutionally protected but politically constrained.
  • Look-through alternative. A minority view (more common among ECB doves in 2022-2023) holds that supply shocks should be looked through to avoid unnecessary output loss. The September 2026 decision decisively rejected this view in favor of the energy-shock framework.

Cross-References

Significance

This concept is Tier 2 important because it provides the macro frame for understanding why 2026 differs from prior supply shocks (1973, 1979, 1990, 2022). The reaction-function shift means rates stay higher for longer, risk-asset multiples compress, and the 2027 "structural surplus" thesis (per structural-surplus-2027 and JPM's End-of-War scenario at $64 Brent) may be undercut by monetary policy itself. It also explains why the diesel/distillate story is now central: the central bank reaction function responds to the most persistent and transmittable energy prices, which by September 2026 means diesel/gasoil — not Brent.

The energy-shock reaction function is the bridge between the supply-side crisis (supply-destruction, refined-products-as-shock-center, hotel-california-phase) and the macro policy response (ECB rate hikes, Fed pivot, EUR strength, equity market stress per MS equity strategy). Without this concept, the connection between the war and the rate hike cycle is opaque.

Created 2026-09-13 — kb-full-ingest / 1.2-concept-extraction