By Francesco Canepa and Balazs Koranyi FRANKFURT, March 19 (Reuters) - The European Central Bank kept its key interest rate at 2% on Thursday and warned that the war in Iran was clouding the outlook
ECB flags inflation risk as Iran war sends energy prices soaring
By Francesco Canepa and Balazs Koranyi
ECB Policy Response to Energy Price Surge
FRANKFURT, March 19 (Reuters) - The European Central Bank kept its key interest rate at 2% on Thursday but policymakers expect to discuss hikes in the coming months as the Iran war pushes up inflation in the euro zone.
Oil and gas prices have jumped since U.S.-Israeli attacks on Iran began, raising the risk that higher energy costs will drive up consumer prices and depress economic activity across the 21-nation currency bloc, which relies heavily on imported fuel.
Impact of Middle East Conflict on Inflation
"The war in the Middle East ... will have a material impact on near-term inflation through higher energy prices," the ECB said in its policy statement. "Its medium-term implications will depend both on the intensity and duration of the conflict and on how energy prices affect consumer prices and the economy."
Unless the conflict is quickly resolved, ECB policymakers are likely to start a discussion on interest rate hikes in April and possibly tighten policy at their subsequent meeting in June, three sources told Reuters.
Potential Triggers for Rate Hikes
A rate rise at the ECB's April 29-30 meeting would require an even bigger surge in energy prices, with one of the sources mentioning a $200 per barrel oil price as a potential trigger. Benchmark Brent crude touched $119 per barrel on Thursday.
The ECB itself said on Thursday that a "severe" scenario under which crude peaks at almost $150 per barrel by June, would likely require "tighter monetary policy".
ECB's Position and Resilience
Well Positioned to Deal with Shock
WELL POSITIONED TO DEAL WITH SHOCK
Commenting on Thursday's decision, ECB President Christine Lagarde chose not to repeat her recent mantra that the central bank was "in a good place". Instead, she said the euro zone was resilient and that low inflation meant it was "well positioned" to deal with what she called "a major shock that is unfolding".
"We start from a good position, and we are well positioned to demonstrate our capacity to apply our strategy and to be agile to do what is necessary," Lagarde told a press conference.
Monitoring Market Reactions
She said policymakers were paying close attention to moves in energy and commodity markets and how they influenced wage demands, consumer behaviour and companies' price-setting.
Central banks in the United States, Canada, Japan, Britain, Sweden and Switzerland delivered broadly similar messages earlier in the day or on Wednesday.
Market Expectations and Inflation Outlook
Financial markets now expect inflation in the euro zone to climb close to 4% over the next year, then take years to return to the ECB's 2% target.
Traders are pricing in two or three rate hikes by December, even as most economists still see no change, betting that the ECB would not tolerate another war-fuelled spike in inflation after being stung by Russia's 2022 invasion of Ukraine.
With Thursday's decision, the ECB left its policy rate at 2%, roughly matching February inflation, which pre-dates the first attacks on Iran on February 28.
Historical Context and Policy Lessons
Painful Precedent Has Left Scars
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 Moscow's full-scale attack on Ukraine, 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 Evolving Approach
"In those four years, we have learned," Lagarde said, noting that interest rates are now higher, inflation lower and the labour market less overheated than four years ago, when the economy was re-emerging from the COVID-19 pandemic. "I think we also understand better the mechanism of the pass-through into indirect and second-round effects."
Fiscal Policy Implications
Investors are already bracing for higher government borrowing in response to the Iran crisis - a shift that comes on top of Germany's plans to sell more debt to ramp up military and infrastructure spending.
That could further fuel inflation and has already pushed up bond market borrowing costs before any rate hike by the ECB.
Lagarde said governments should spend parsimoniously.
"Any fiscal responses to the energy price shock should be temporary, targeted, and tailored," she said.
(Editing by Catherine Evans)
