ECB to talk tough as Iran war raises inflation fears

ECB keeps rates on hold as Iran war clouds outlook

ECB Decision and Economic Implications

(Fixes typo in paragraph 3)

By Francesco Canepa and Balazs Koranyi

ECB Holds Rates Amid Geopolitical Uncertainty

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 for growth and inflation in the euro zone.

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 and depress activity across the 21-nation currency bloc, which relies heavily on imported fuel.

"The war in the Middle East ... will have a material impact on near-term inflation through higher energy prices," the ECB said. "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."

The euro zone's central bank kept its options open, however, saying it was monitoring the war and its impact on inflation, both including and excluding energy prices, and growth.

"The Governing Council is well positioned to navigate this uncertainty," the ECB said. "Inflation has been at around the 2% target, longer-term inflation expectations are well anchored, and the economy has shown resilience over recent quarters."

Global Central Bank Responses

Central banks in the United States, Canada, Japan, Britain, Sweden and Switzerland delivered broadly similar messages earlier in the day or on Wednesday.

Market Reactions and Expectations

Financial markets now expect euro zone inflation 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 invasion of Ukraine four years ago.

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.

Investors' focus will now turn to ECB President Christine Lagarde's news conference starting at 1345 GMT.

ECB's New Scenarios for Growth and Inflation

Updated Projections

ECB'S NEW SCENARIOS FOR GROWTH, INFLATION

The ECB's updated quarterly projections put inflation at 2.6% in 2026, 2.0% in 2027 and 2.1% in 2028. Growth was seen at 0.9%, 1.3% and 1.4%.

Adverse Scenario and Energy Shocks

But the central bank was also expected to publish an adverse scenario later on Thursday, predicated on higher energy costs.

"The implications for medium-term inflation depend crucially on the magnitude of indirect and second-round effects of a stronger and more persistent energy shock," the ECB said.

Barclays' Analysis

Economists at Barclays said the ECB would raise rates in a scenario where Brent crude settled at around $100 a barrel, compared to $113 on Thursday, and natural gas at 70 euros per megawatt-hour, just above current prices.

"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.

Painful Precedent Has Left Scars

Lessons from the Past

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 2022 invasion of 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.

Policy Shifts and Consumer Sentiment

"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," HSBC economist Fabio Balboni said.

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.

More Fiscal Spending Ahead?

Government Borrowing and Bond Markets

MORE FISCAL SPENDING AHEAD?

But 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.

ECB's Stance on Credit Conditions

For now, however, the ECB is expected to tolerate this tightening of credit conditions.

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

(Editing by Catherine Evans)