ECB Holds Steady Amid Inflation Fears and Geopolitical Uncertainty

ECB Set to Hold Rates Amidst Rising Inflationary Pressures

The European Central Bank (ECB) is widely expected to maintain its interest rates unchanged on Thursday, opting for a cautious approach to meticulously evaluate the inflationary shock that the escalating conflict in Iran might unleash. The consensus among economists is that the deposit rate will remain at its current 2% level when the decision is announced on Thursday evening Beijing time. While the majority of economists believe borrowing costs will stay put through the end of the year, traders are pricing in the possibility of at least one further rate hike.

Concerns Over a New Inflation Wave

The ongoing conflict in the Middle East is casting a shadow of apprehension, raising fears of a subsequent inflationary surge following the price hikes witnessed in 2022. As major central banks convene this week, this prospect has rapidly ascended to the top of their agendas. The ECB finds itself in a considerably more comfortable position than during the period when the Russia-Ukraine conflict sent oil and gas costs soaring. Nevertheless, some policymakers are already contemplating whether interest rate hikes might be necessary to contain any nascent inflationary risks. Conversely, others are more concerned about the potential dampening effect such measures could have on economic expansion, presenting a more vexing challenge.

Limitations of New Forecasts and Scenario Analysis

The latest quarterly projections are unlikely to provide substantial guidance, as many of the inputs were gathered before the recent strikes initiated by the US and Israel. However, the accompanying scenario analyses are anticipated to offer crucial clues, shedding light on the potential trajectory of the situation should it deteriorate further. ECB President Christine Lagarde has pledged to "not make rash decisions," while simultaneously promising to "never again" allow Europeans to endure a repeat of the "runaway inflation" experienced four years ago. She is scheduled to face intense media scrutiny half an hour after the policy announcement, before heading to Brussels for an EU summit discussing the Iranian situation.

Energy Market Outlook: A Relative Calm

On the energy front, the situation appears relatively more benign. Supply chains have become more diversified, and while natural gas prices have seen an uptick, they remain significantly below previous peaks. This diversification and stabilization in energy markets may offer some respite, but the broader inflationary picture remains complex.

Impatience from Businesses and Consumers, and Inflation Expectations

However, businesses and consumers might not possess the same degree of patience. Current inflation expectations have already surpassed the 2% target, and with the inclusion of higher energy costs, these expectations are likely to climb further. This could create renewed pressure on the ECB to act decisively.

Forecasting Challenges and Uncertainty Factors

The limitations inherent in the assumptions underpinning these new forecasts will significantly curtail their utility in predicting inflation and economic growth trajectories. The duration of the conflict in Iran remains a highly uncertain variable. Statements regarding US troop withdrawal have varied, adding to the ambiguity. Furthermore, the cut-off dates for key market indicators incorporated into the forecasts present a more technical challenge. If the ECB adheres to its conventional schedule, these dates would likely precede the outbreak of hostilities, thereby impacting the accuracy of the projections.

Interest Rate Path: Balancing Caution and Market Speculation

Officials have consistently emphasized the importance of maintaining composure in the face of the Iranian conflict, stating that it is too early to draw definitive conclusions about the future path of interest rates. However, this stance has not deterred some from speculating about the necessity and timing of potential rate hikes. Ritva Mullo, Governor of the Bank of Estonia, has indicated that the probability of a further rate hike has increased. Similarly, Peter Kazimir, Governor of the National Bank of Slovakia, stated in an interview that "the time for the ECB to react might be closer than many think."

Simona Delle Chiaie, Chief Eurozone Economist at Bloomberg, suggests that "at the meeting, the ECB might lean more towards intervening with "jawboning" (rhetoric) rather than "hiking" (action). The market might be "buying insurance" against reliving the 2022 crisis, but in our view, the bar for actual tightening remains high."

Traders are currently pricing in expectations of one or two 25-basis-point rate hikes this year. However, a survey conducted between March 6th and 11th revealed that only 7% of analysts anticipated a December hike. Isabelle Mateos y Lago, Chief Economist at BNP Paribas, commented in an interview on Wednesday that "at this stage, it is clearly far wiser to send a signal of vigilance, even hawkishness, and pray that they ultimately do not need to take actual action."

Economic Landscape Contrasts with 2022

Despite the recent surge in energy prices evoking memories of 2022, when inflation peaked above 10%, officials are working to allay fears of Europe repeating that experience. Lagarde is likely to reiterate her view that the current economic conditions are fundamentally different. There is no pent-up demand, no overheating labor market, and no expansionary fiscal policy environment. The same applies to monetary policy: interest rates were negative then, and the ECB was engaged in aggressive bond purchases. Now, borrowing costs are nearing neutral levels, and the balance sheet is shrinking.

Isabel Schnabel, a member of the ECB's Executive Board, stated that these projections "will at least partially reflect recent developments." Lagarde has also hinted that the ECB will again employ its scenario analysis tools. In 2023, ECB economists simulated scenarios of a prolonged escalation of the Middle East conflict and a partial closure of the Strait of Hormuz. The results indicated that this would significantly boost energy-driven inflation and severely depress economic output.

Lagarde's Future and Potential Leadership Shuffle

Lagarde may also face questions regarding her personal future. Reports have suggested she might depart the ECB early to allow French President Emmanuel Macron to facilitate the appointment of her successor before the French elections. She has offered a muted denial, effectively leaving the door open for an early departure. This could precipitate a broader reshuffle at the top of the ECB: half of the six Executive Board members are due to be replaced by 2027, and France is reportedly eyeing the Chief Economist position, which will become vacant six months before Lagarde's term concludes.