The European Central Bank is expected on Thursday to become the first major central bank to raise interest rates in response to rising inflation caused by the war in the Middle East.
Policymakers, who set interest rates for the 21 countries that use the euro, are expected by economists and investors to raise their key rate by a quarter percentage point to 2.25 percent. This will be the first increase by the bank after September 2023.
The rate increase would be a decisive step toward countering some of the economic consequences of the war, which has closed the Strait of Hormuz, a vital waterway for energy and other goods from Iran’s southern coast, for more than three months. In May, inflation in the eurozone stood at 3.2 percent, driven by higher energy prices and well above the central bank’s target of 2 percent. Before the war the inflation rate was just under 2 percent.
“Whatever happens with the conflict, you could argue that inflation has been hurt a lot in the short term,” said Frederic Ducrozet, head of strategy and macro research at Pictet Wealth Management. Policymakers are right to recognize that even when the strait reopens, energy supply disruptions will not end immediately and “inflation risks” remain, he said.
High prices for energy, fertilizers and other commodities exported through the strait from the Persian Gulf are driving inflation around the world. Rising costs are weighing on economic growth, forcing central bankers to balance the risks of higher inflation against the risks of a recession.
Several countries, including South Africa, Australia and Norway, have raised rates since the war began in late February. The Bank of Japan is expected to raise rates next week for the first time since December. In the United States, where prices are rising at the fastest pace in three years, the Federal Reserve will also meet next week. The Fed is not expected to change rates, but there is growing speculation among investors that it will raise rates at the end of the year.
For the past year, the European Central Bank has kept rates at 2 percent, a level that is intended to neither boost the economy nor constrict it. While Europe grappled with how to improve competitiveness and generate sustained growth, policymakers hoped that keeping rates low would, in the short term, support the economy through greater consumer spending and business investment.
Instead, those hopes were quickly dashed by conflict in the Middle East. Rising energy prices have increased uncertainty and unpredictability. Economists have increasingly begun to predict higher inflation, slower economic growth and even recession, evaluating a range of adverse scenarios.
In March, shortly after the war began, ECB staff projected that inflation would average 2.6 percent this year and return to 2 percent the following year. The bank is expected to remove those estimates this week.
Still, the eurozone economy shows no signs of a repeat of 2022, when Russia invaded Ukraine. Europe reacted by cutting itself off from Russian gas, a vital energy supply, and inflation reached double digits. So far, traders aren’t betting that this is the beginning of a long and aggressive cycle of rate hikes. But they will be closely watching ECB President Christine Lagarde’s press conference on Thursday for any indication of what the central bank will do in the coming months.
The ECB is assessing high inflation against signs of any economic slowdown caused by the war. Consumer confidence has declined and there could be further pressure on spending, while businesses and governments are using the money to pay for higher energy costs. The central bank is expected to lower its growth projections for this year and next.
To some extent, slower growth may ease the pressure for higher prices. If consumers become more nervous about spending, it may be difficult for companies to raise prices. Also, if the labor market is weak, workers will not be able to push for higher wages. This can prevent inflation from increasing rapidly or for a long time.
The prospect of a deep recession has some economists concerned that the rate hike could be a mistake. He compared it to 2011, when the ECB, under the leadership of Jean-Claude Trichet, had raised rates twice in the first half of the year, but Mr Trichet’s successor Mario Draghi cut rates a few months later.
Mr. Ducrozet, the strategist, said he does not believe it is necessary for the ECB to raise interest rates because he sees no sign of so-called second-round effects, in which higher energy costs lead to higher wages.
The bigger issue, he said, is how officials explain what will happen next.
“How aggressive will they be in stabilizing the economy if it does not shrink?” He added. “It concerns me more than this week’s move.”
