Key Points:
- The European Central Bank will likely keep its main interest rate at 2.0% on Thursday.
- The ongoing US-Israel war with Iran caused a massive spike in global oil and gas prices.
- Financial markets predict inflation will rise above 3.0% over the next year.
- Traders are betting the ECB will raise interest rates twice before December to fight inflation.
The European Central Bank faces a massive test this Thursday. Economists are almost completely certain that the bank will keep its main interest rate on hold at 2.0%. However, officials will use their public statements to send a clear warning to the markets. The ECB wants everyone to know it stands ready to raise interest rates immediately if the ongoing war in Iran causes a permanent spike in European inflation.
The economic landscape changed violently at the end of February. When the US and Israel launched military attacks on Iran, global oil and gas prices jumped overnight. This sudden energy shock poses a massive risk to the 21 nations that use the euro currency. Because these countries rely heavily on imported fuel, expensive oil quickly translates into higher prices for everyday consumer goods.
Financial markets are already bracing for the worst. Traders currently expect European inflation to climb above 3.0% over the next 12 months. They believe it will take four long years for prices to slowly drift back down to the ECB’s official 2.0% target. Because of this grim outlook, traders are actively betting that the central bank will panic and hike rates twice before December, even though most professional economists disagree.
Central bankers across the euro zone admit the situation looks bleak. They warn that the war will undoubtedly push inflation up and drag economic growth down. The real problem is that no one knows how big the hit will be. The final economic damage depends entirely on how long the military conflict lasts, a factor that financial experts simply cannot predict right now.
Because of this intense uncertainty, ECB President Christine Lagarde and her team will likely focus on projecting strength rather than taking immediate action. Ebrahim Rahbari, head of rates strategy at Absolute Strategy, explained the bank’s likely approach. He noted that while the ECB does not expect to hike rates anytime soon, officials desperately want to project total vigilance to keep the public calm.
Other major central banks are following this same playbook. The Bank of England, Sweden’s Riksbank, and the Swiss National Bank will all announce their own policy decisions on Thursday with similar cautious messaging. On Wednesday, the US Federal Reserve also chose to leave its rates unchanged. The Fed even kept the possibility of a rate cut on the table for later this year, despite raising its own inflation forecast due to the unpredictable energy markets.
The ghosts of recent history haunt the halls of the European Central Bank. In 2022, when Russia invaded Ukraine, energy prices exploded. The ECB initially brushed off that surge, calling it a temporary problem. That mistake cost them dearly. They were eventually forced to raise borrowing costs sharply and faced intense public criticism for reacting too late. Because consumers still feel scarred by that recent cost-of-living crisis, economists believe the ECB might pull the trigger on rate hikes much faster this time around if energy pressures do not fade quickly.
The ECB plans to release its updated quarterly forecasts for growth and inflation on Thursday. While these numbers will not capture the full impact of the recent Iranian conflict, the bank will publish several different scenarios. These scenarios will outline exactly how the European economy might react if the war ends tomorrow or if it drags on for months.
Economists at Barclays have already run the numbers. They predict the ECB will definitely raise rates if Brent crude oil settles around $100 a barrel and natural gas stays near 70 euros per megawatt-hour. In that specific scenario, core inflation would rise so high that the central bank would have no choice but to increase policy rates later this year.
Meanwhile, bond markets are already tightening the screws on the European economy. Investors expect governments across Europe, especially Germany, to borrow massive amounts of money to fund new military and infrastructure projects in response to the Iran crisis. This expectation is driving government bond yields higher, which naturally pushes up borrowing costs for regular companies and households. For now, the ECB seems perfectly willing to tolerate this credit tightening if it helps prevent inflation from infecting workers’ wages.
