ECB remains cautious in rate decision amid Middle East risks

The European Central Bank (ECB) is preparing to maintain its cautious stance in its monetary policy decision it will announce on Thursday amid escalating geopolitical tensions in the Middle East undermining the inflation outlook.

Central banks are adjusting their policy steps against the backdrop of the negative economic effects of the US-Israel-Iran conflict.

Rising oil prices amid reignited conflicts in the region fuel expectations that energy costs in the eurozone could rise again.

The risk of increasing energy costs spilling over into overall prices via transport, manufacturing, and services sectors makes it more difficult for the ECB to declare victory in its fight against inflation.

Conflicts in the Middle East are once again stoking inflationary pressure via energy prices, fueling expectations that the ECB may act more cautiously over further policy easing.

Markets widely expect the bank to maintain its rates, while anticipating a rate hike at its next meeting.

ECB President Christine Lagarde’s inflation outlook, energy prices, and geopolitical risk assessments will be decisive for the short-term direction of European markets.

The bank’s verbal messaging over whether war-related cost pressures have been temporary or will be persistent will play a key role shaping interest rate expectations for future meetings.

Bas van Geffen, senior macro strategist at Rabobank, told Anadolu that the collapse of the US-Iran ceasefire reduced the likelihood of a more dovish scenario for the ECB, while energy prices returned to levels more generally consistent with the bank’s baseline scenario.

Geffen noted that new uncertainties came to the fore amid reigniting tensions in the Middle East, fueling expectations of a second-half rate hike.

“Lagarde may indicate that this tips the balance more towards upside inflation risks again, but we believe it does not warrant an urgent policy response,” he said, noting that one more rate hike is likely especially in September, rather than this month.

Geffen stated that the renewed escalation of the conflict in Iran is driving up inflation risks, which may embolden some of the more hawkish members of the bank to push for another rate hike in July, but he expects most policymakers will avoid pushing to hike rates again.

“On top of the increase in energy prices, the collapse of the MoU also adds new uncertainty – about the duration and scope of the renewed conflict, for example,” he said.

“That uncertainty could lead to non-linear effects on both inflation and on growth, e.g. through consumer confidence,” he added.

Jan-Paul van de Kerke, senior economist for the Netherlands and the eurozone at ABN AMRO, told Anadolu he expects the ECB to hike rates again in September, bringing the deposit rate to 2.5%.

“This is in order to keep inflation expectations well anchored, as core inflation will likely stay elevated despite the declines in energy prices we are now seeing,” he said.

“Ultimately, however, we expect second round effects to be contained, and by early 2027 we expect the ECB to be confident enough in the inflation outlook to gradually bring rates back to its estimate of a neutral policy setting — we expect one rate cut each in Q2 and Q3 2027, bringing the deposit rate back to 2%,” he added.