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The European Central Bank (ECB) kept interest rates on hold today as it waits to assess the full impact of the Iran conflict on the eurozone. Simultaneous price increases and the drag on demand from an energy price shock is every central banker’s worst nightmare. However, the ECB has signalled that − even though near-term inflation will rise – it’s more focused on the medium-term outlook, which is where the impact is much less clear. It means the ECB is keeping its options open rather than rushing to adjust policy.
ECB economic forecast: stronger inflation and weaker growth
The ECB’s updated outlook sees inflation reach 2.6% this year, although energy prices have risen further since this calculation. Even if that figure ends up higher after this morning’s significant upward price shifts, the good news is the ECB’s projections see inflation fall back fairly quickly to 2% next year. This suggests the ECB is hoping the inflation shock will be temporary and that it can keep inflation expectations managed without needing to raise interest rates. It also means the ECB doesn’t judge the risk of second-round effects to be significant.
Avoiding rate hikes would allow the ECB to avoid dampening demand further in response to the energy price shock. The ECB’s current projections already show growth in 2026 and 2027 at 0.9% and 1.3% respectively, down from 1.2% and 1.4% back in December, due to higher energy prices dampening activity.
Ultimately, the ECB’s central forecast is already somewhat outdated with oil and gas prices sitting between the baseline and its adverse scenario. In the adverse scenario, the ECB sees inflation averaging 3.5% in 2026 but still dropping to 2.2% in 2027. So, for now, the ECB’s Governing Council can continue to stay on hold as long as the risk of second-round effects doesn’t rise further.
Eurozone risks still skewed to rate hikes
ECB President Christine Lagarde is right to state that the ECB is “well positioned and well equipped to deal with the development of a major shock”. The ECB has had more success than other central banks at ensuring inflation returned to 2% following the 2022 invasion of Ukraine. This has kept inflation expectations well-anchored and second-round effects limited. The economic conditions are also different now to 2022, making a surge in second-round effects less likely.
However, the Strait of Hormuz is effectively shut, which will push prices higher. Attacks on energy infrastructure overnight, such as the bombing of Ras Laffan – the world’s largest liquefied natural gas plant – makes a quick fall in energy prices even more unlikely given the time needed to rebuild facilities and restart production. In any case, we still think the ECB will want to look through the shock. However, if households’ inflation expectations start to rise, and second-round effects from wage bargaining and price hikes seem likely, then the ECB will have to act.
In any case, while the risks to interest rates are clearly skewed towards hikes, financial markets pricing in two rate rises with a 50:50 chance of a third by the end of the year is probably a step too far currently.
