FRANKFURT - The European Central Bank (ECB) is widely expected to keep its main policy rate at 2% when it announces its decision on Thursday, while making clear it is prepared to raise rates if the conflict involving Iran triggers a sustained rise in euro area consumer prices.
Since the start of U.S.-Israeli strikes on Iran, oil and gas prices have climbed, heightening the risk that elevated energy costs will feed through to inflation in the 21-country currency bloc, which depends heavily on imported fuels. Financial market pricing reflects that concern - traders now anticipate inflation rising above 3% over the coming year and then only gradually reverting toward the ECB's 2% target over the subsequent four years. Markets are even pricing in two rate increases by December, although most professional economists continue to expect no immediate tightening.
Policymakers across the euro area have warned that the Iran war will tend to push inflation higher and weaken growth. The magnitude of the effect, however, hinges on the duration of the conflict - a factor officials concede is currently opaque. That uncertainty is likely to lead President Christine Lagarde and her colleagues to favor strong rhetoric and conditional guidance over immediate policy moves, signaling readiness to act without committing to a particular path.
"The ECB isn’t expecting to hike any time soon but equally at this point will want to project vigilance," said Ebrahim Rahbari, head of rates strategy at Absolute Strategy. Similar cautious-but-watchful messages are anticipated from other central banks that will also decide policy this week, including the Bank of England, Sweden’s Riksbank and the Swiss National Bank.
The U.S. Federal Reserve, which concluded its policy meeting late on Wednesday, left interest rates unchanged and did not rule out a rate cut later in the year. Still, the Fed raised its inflation forecast and said it had low conviction in its projections given the exceptional uncertainty around energy prices and the duration of the war.
Historical experience shapes caution
Although textbook guidance typically advises central banks to look through temporary supply shocks - such as the current disruptions affecting the Strait of Hormuz - many ECB officials remain mindful of the painful experience following Russia’s 2022 invasion of Ukraine. At that time, the ECB initially treated the energy-driven spike in prices as transitory and was subsequently forced, along with other major central banks, into a rapid sequence of rate hikes amid criticism it had reacted too late.
HSBC economist Fabio Balboni warned that the 2022 episode and the lingering impact on consumers' expectations could make the ECB quicker to tighten policy if energy pressures persist. Isabel Schnabel, a noted member of the ECB's hawkish wing, has also highlighted the "scars" left on households and businesses by that episode, while noting an important difference today: monetary and fiscal settings are not loose, which should help limit inflationary pressures.
At present, the ECB's key policy rate of 2% is roughly in line with February inflation readings, which pre-date the first attacks on Iran on February 28.
Scenarios, forecasts and the role of energy
Alongside its policy decision, the ECB will publish updated quarterly forecasts for growth and inflation. Those projections are not expected to fully capture any immediate effects from the Iran war on energy prices. More notably, the central bank is set to release scenario analyses describing how the economy could evolve if the conflict ends quickly versus if it becomes prolonged.
Economists at Barclays have suggested that the ECB would likely raise rates in a scenario where Brent crude settles around $100 per barrel - roughly the then-current level - and natural gas trades near 70 euros per megawatt-hour, about 15 euros higher than the level earlier in the week. They wrote that under such conditions, both headline and core inflation could increase enough that an overshoot relative to the ECB’s medium-term target would become material and persistent, prompting the bank to raise its policy rate later in the year. Barclays also noted that the macroeconomic and monetary outlook will depend in part on fiscal responses to the crisis.
Fiscal responses, bond markets and credit conditions
Government bond markets are already pricing in the prospect of increased fiscal outlays in response to the Iran situation - a shift that compounds Germany’s existing plans to step up military and infrastructure spending. Rising sovereign yields are likely to lift borrowing costs for households and businesses across the euro area even without an ECB rate rise. For now, the central bank appears prepared to tolerate some of that market-driven tightening in credit conditions.
Consultant Spyros Andreopoulos of Thin Ice Macroeconomics said the priority at this stage must be to prevent second-round effects - specifically the risk that higher inflation expectations take hold and begin to show up in wage demands.
Outlook and policy posture
With considerable uncertainty around how long the conflict will last and how energy markets will respond, the ECB is expected to emphasize contingency planning and scenario-based communication. The bank’s approach is likely to lean toward vigilance and readiness to tighten if the Iran war produces a sustained and broad-based rise in inflation, while holding fire in the immediate term unless the data point clearly in that direction.