ECB and BoE hold rates steady as 2 banks weigh war's impact

The European Central Bank and the Bank of England will leave their key interest rates unchanged this week, as the uncertain duration of the energy shock from the Middle East conflict pushes both institutions into a wait-and-see mode.

"The stop-start nature of the conflict—war, ceasefire, peace talks, their collapse, a naval blockade, its lifting, its reinstatement—makes it exceptionally hard to gauge the duration and depth of the consequences," ECB President Christine Lagarde said in a speech last week.

The decision comes after inflation accelerated in March, with Eurozone consumer prices rising 2.6 percent from a year earlier, up from 1.9 percent in February. U.K. inflation climbed to 3.3 percent. Despite the price pressures, markets have pared back bets on aggressive rate hikes, anticipating that policymakers will wait for more data.

At stake is the central banks' ability to navigate a narrow path that avoids both a recession and a persistent wage-price spiral. With the Strait of Hormuz still largely closed, policymakers are signaling that the next real opportunity to act will be in June, by which time they will have a clearer picture of wage growth and inflation dynamics.

Both central banks are confronting a classic stagflationary threat. The surge in energy prices is feeding inflation while simultaneously depressing business activity and consumer confidence. Germany has already cut its 2026 and 2027 growth forecasts and raised its inflation estimates. Euro zone business activity contracted in April, according to recent surveys, with factories facing the fastest rise in production costs in 37 months.

The primary concern for rate-setters is the potential for "second-round effects," where higher energy prices lead to sustained wage demands and broader price increases. For now, there are few signs of this. An ECB survey on Monday showed firms' longer-term inflation expectations remained steady, and wage growth was seen moderating. Similarly, the Bank of England's regional agents reported that 2026 pay deals averaged around 3.5 percent, only slightly above the level consistent with their 2 percent inflation target.

Unlike the energy crisis of 2022 following Russia's invasion of Ukraine, the current shock's inflationary impact may be more limited. According to economists at Citi, the European economy and labor markets are weaker now than they were post-pandemic. Furthermore, inflation was already well above target in 2022, whereas it was closer to the 2 percent goal before the Iran war broke out. This gives central banks slightly more room to hold fire.

While an immediate rate hike is off the table, markets are still pricing in the possibility of future action. Traders anticipate at least two hikes from the ECB later in 2026, likely starting in June, if the Strait of Hormuz remains closed and oil prices stay elevated. "They do need to put up rates a little bit just to make sure that secondary effects don't kick in," said David Zahn, head of European fixed income at Franklin Templeton. The ECB is seen as more likely to move first, as its key rate is considered neutral, while the BOE's is still seen as restrictive to growth. The next meetings for both central banks are in June.

This article is for informational purposes only and does not constitute investment advice.