ECB warns of risks from war as it holds rates

The European Central Bank held interest rates steady on Thursday but signalled a possible increase ahead as it warned of growing risks to the growth and inflation outlook due to the war in the Middle East.

Energy costs have surged since the near-total closure of the Strait of Hormuz, through which about a fifth of the world’s oil and gas usually passes, following the outbreak of the US-Israeli war against Iran.

“The increase in energy prices will keep inflation well above two percent in the near term,” ECB president Christine Lagarde said at a press conference. “As the period of high energy prices extends, the likely impact on broader inflation through indirect and second round effects intensifies,” she added.

The ECB’s decision to hold its key deposit rate at two percent, where it has been since June last year, was in line with analysts’ expectations, as the bank waits to see how the war plays out and for more data to gauge its impact on the eurozone economy.

Lagarde told journalists the ECB had made a unanimous decision to keep rates where they were on the basis of “insufficient information”, adding that some indicators nevertheless showed the economy moving away from the bank’s more benign baseline scenario.

“We are certainly moving away from the baseline,” Lagarde said. “I think directionally I know where we’re heading.”

Eurozone economic growth slowed to 0.1 percent in the first three months of the year, official data showed Thursday, and eurozone inflation jumped to three percent in April, well above the ECB’s two-percent target.

Though Lagarde said the ECB was so far not seeing second-round effects that would add to inflationary pressure, analysts detected a hawkish tone in her comments and suggested that a rate rise was on the way.

Lagarde began the press conference by noting that rate-setters had debated “at length and in depth a decision to possibly hike”.

“The mention of a rate hike debate clearly suggests that the ECB has moved closer to a rate hike at the June meeting,” said ING bank economist Carsten Brzeski.

“The main take-away from today’s ECB meeting can probably be described as another hawkish shift.”

The Middle East war energy shock leaves the ECB on the horns of a dilemma, since interest rate rises -- the typical tool to combat inflation -- also hit economic growth by making borrowing more expensive.

Asked about the risk of “stagflation”, typically seen as a nightmare scenario for central banks combining low growth with high inflation, Lagarde said the eurozone economy was not stagnant and that inflation would be controlled.

“Our monetary policy framework is strong enough and our strong determination is solid enough,” she said. “We will bring inflation back to two percent.”

Much of the inflation and growth outlook depends on whether Iran and the United States can come to a lasting agreement that secures transit of energy supplies through the Strait of Hormuz, a factor over which the ECB has no control.

Speaking in Berlin earlier this month, Lagarde said the institution was facing “double uncertainty” in that it was unclear both how long the shock would last and what its effect on the broader economy would be.

ECB officials have also been keen to stress the difference between the situation now and that after Russia’s full-scale invasion of Ukraine in 2022, when some criticised the central bank for moving too slowly in its response to surging inflation.

An energy shock coupled with post-pandemic supply chain woes and tight labour markets at the time helped push eurozone inflation to record highs.

Asked to compare the situation now with then, Lagarde said wage and price data over the coming weeks would help the ECB to form a view by June, adding that geopolitics could easily intervene.

“There is an ocean of uncertainty,” she said. “Things might change for the good or for the bad.”