European Central Bank may hike rates amid conflict-induced inflation shocks

BERLIN

Escalating tensions in the Middle East following the joint US-Israeli attacks on Iran, as well as sharp increases in oil prices in response to Tehran's retaliatory attacks on US bases and targets in the Middle East, triggered an inflation shock for the European Central Bank (ECB).

The ECB will convene on March 19 for a critical interest rate meeting, while estimates in the money markets show that the bank may have to resort to a rate hike, an option that has long been shelved until recently.

Despite US President Donald Trump’s optimistic statements, economists say the war does not seem to be ending any time soon and that the emerging situation could directly affect monetary policies.

The ECB is expected to have shifted from a wait-and-see approach to a more hawkish stance ahead of the meeting, with officials hinting that interest rates may rise if energy prices drive up overall inflation in the medium term.

Speaking at the Frankfurt School, ECB Executive Board member Isabel Schnabel said the bank is closely monitoring energy price developments and the impact on inflation.

Germany's Bundesbank President Joachim Nagel said the ECB will take decisive action if energy prices affect consumer inflation in the medium term, while ECB President Christine Lagarde said the bank will do whatever it takes to avoid a repeat of the inflation shock four years ago.

She noted that preventing a new wave of price hikes due to the conflict in the Middle East is vital in handling the situation, as the bank is on alert not to repeat the case of the Russia–Ukraine War.

⁠Some members of the ECB signaled more concrete steps, such as Peter Kazimir, the governor of Slovakia’s National Bank, who said the ECB’s response may be closer than expected, while Madis Muller from the Bank of Estonia said the likelihood of a rate hike by the ECB rose in the last two weeks.

Meanwhile, inflation estimates are being revised, as senior economist Andrzej Szczepaniak raised his year-end inflation estimate for the eurozone from 2.1% to 2.7%, above the ECB’s 2% target, while inflation currently stands at 1.9% amid rising oil and gas prices.

The International Energy Agency (IEA) proposed releasing a record 400 million barrels of oil reserves to ease the markets—the amount represents double the reserves released at the start of the war in Ukraine in 2022.

Tensions in the oil market reached a more serious level than the level in the period after the apex of the Russia–Ukraine war.

Carsten Brzeski, global head of macro research and chief eurozone economist at ING, said in his analysis on Wednesday that the ECB’s trauma since the Russian invasion of Ukraine in 2022 is still fresh.

“In a ‘forever war’ scenario of a longer-lasting disruption of the Strait of Hormuz, oil prices above $100/b for several months and knock-on effects on transportation, food prices, and more generally supply chains are likely to force the ECB’s hand and consider rate hikes,” he said, noting that rate cuts in this scenario are completely off the table with the way things are.

“We don’t expect Lagarde to repeat the phrase ‘good place.’ There is still no reason for the ECB to panic—but installing a panic room within that ‘good place’ might not seem like such a bad idea for now,” he added.

Brzeski stated that the ECB historically deemed inflation as temporary in past oil shocks, especially in 2021–2022, but that mistake is now ingrained in the bank’s institutional identity.

Even if the ECB maintains rates next week, the bank is expected to use its “second most powerful policy instrument, words.”

The verbal guidance from the bank may send a message to the markets that “the ECB stands ready to act,” he said.

He noted that any new growth or inflation estimates by ECB experts come out outdated at the time of publishing due to the sudden movements in oil prices, adding that geopolitical realities, instead of model-based forecasts, will shape the bank’s course.

*Writing by Emir Yildirim in Istanbul