ECB to Talk Tough as Iran War Raises Inflation Fears

ECB to Maintain Interest Rates Amid Growing Inflation Risks from Iran War

ECB's Response to Inflation Risks and the Iran War

By Francesco Canepa and Balazs Koranyi

FRANKFURT, March 19 (Reuters) - The European Central Bank is all but certain to keep interest rates on hold at 2% on Thursday but will make clear it stands ready to raise them if the Iran war fuels a lasting surge in euro zone inflation.

Oil and gas prices have jumped since the U.S.-Israeli attacks on Iran began, raising the risk that higher energy costs will drive up consumer prices across the 21-nation currency bloc, which relies heavily on imported fuel.

Financial markets now expect inflation to climb above 3% over the next year and only slowly drift back toward the ECB's 2% target in the four years that follow. Traders are betting on two rate hikes by December, even as most economists still see no change.

Central bankers from across the euro zone have warned that the war will push inflation up and growth down. But the size of the hit depends on how long the conflict lasts - a variable they admit they have little visibility on for now.

ECB's Communication Strategy

That means ECB President Christine Lagarde and colleagues are likely to stick to signalling rather than action, offering reassurance they will respond if needed without committing to anything prematurely.

"The ECB isn't expecting to hike any time soon but equally at this point will want to project vigilance," Ebrahim Rahbari, head of rates strategy at Absolute Strategy, said.

Similar messages are expected from the Bank of England, Sweden's Riksbank and the Swiss National Bank, which will also announce policy decisions on Thursday.

The U.S. Federal Reserve, meeting late on Wednesday, left rates unchanged and even kept a rate cut for later this year on the table. But it raised its inflation forecast and said it had low conviction in its own projections given exceptional uncertainty around energy costs and the duration of the war.

Painful Precedent and Lessons Learned

Impact of Previous Energy Crises

PAINFUL PRECEDENT HAS LEFT SCARS

Economics textbooks say central banks should look past temporary supply restrictions, such as the current closure of the Strait of Hormuz - a point underlined this week by the Bank for International Settlements.

But for many ECB policymakers the Iran war will revive memories of the energy-driven surge in inflation that followed Russia's invasion of Ukraine in 2022, which the ECB initially wrote off as transitory.

With other central banks across the developed world, it was then forced to raise borrowing costs sharply amid criticism it had reacted too late.

ECB's Current Stance and Policy Rate

"The experience of the 2022 energy crisis, and consumers' expectations still scarred from that episode, could make the ECB quicker to hike if energy pressures are sustained," said HSBC economist Fabio Balboni.

Isabel Schnabel, a prominent anti-inflation "hawk" among ECB policymakers, has also warned about the "scars" that episode left on households and businesses. She notes an important difference, however: monetary and fiscal policies are not loose this time, which should help limit inflationary pressures.

The ECB's key policy rate stands at 2%, roughly matching February inflation, which pre-dates the first attacks on Iran on February 28.

ECB's Economic Projections and Scenarios

Growth and Inflation Forecasts

ECB TO DRAW SCENARIOS ABOUT GROWTH, INFLATION

The ECB will give updated quarterly forecasts for growth and inflation on Thursday, although these projections will not fully reflect the impact of the Iran war on energy prices.

More importantly, the central bank is expected to publish scenarios outlining how the economy might evolve if the conflict ends quickly or if it drags on.

Potential Rate Hikes Based on Energy Prices

Economists at Barclays said the ECB would raise rates in a scenario where Brent crude settled at around $100 a barrel, roughly its current level, and natural gas at 70 euros per megawatt-hour, some 15 euros above where it was on Wednesday.

"Headline and core inflation could increase to a point where the overshooting from the ECB's target in the medium term would become large and persistent, leading the (ECB) to increase policy rates later this year," they wrote in a note.

"The macro and monetary outlook, however, will also depend on the fiscal response to this crisis."

Fiscal Policy and Market Reactions

Government Borrowing and Bond Markets

MORE FISCAL SPENDING AHEAD?

Bond markets are already bracing for higher government borrowing in response to the Iran crisis - a shift that adds to Germany's plans to ramp up military and infrastructure spending.

This rise in government bond yields is likely to push up borrowing costs for euro zone companies and households even before any ECB rate hike. But for now, the ECB is expected to tolerate this tightening of credit conditions.

Preventing Second-Round Effects

"The objective at this stage has to be to prevent second-round effects – inflation expectations from rising and, in particular, manifesting themselves in wages," said Spyros Andreopoulos, founder of the Thin Ice Macroeconomics consultancy.

(Editing by Catherine Evans)