ECB and Bank of England set to hold rates as Iran conflict fuels stagflation fears

The European Central Bank and the Bank of England announce their latest monetary policy decisions on Thursday, each confronting an uncomfortable combination: inflation still above target and economic growth that the Iran conflict has already started to erode. Since the war erupted in late February, energy prices have surged, reversing the disinflationary trend that had allowed both institutions to contemplate rate cuts earlier in the year. Instead, financial markets briefly priced in a series of hikes. The consensus among economists has since shifted back toward patience.

Eurozone inflation came in at 3% in April, according to the flash estimate from Eurostat, while the UK rate jumped to 3.3% in the twelve months to March, up from 3% a month earlier, per the Office for National Statistics. Both remain uncomfortably above the 2% medium-term targets. Yet the ECB's deposit facility rate sits at 2% and the BOE's Bank Rate at 3.75%, levels that were already restrictive before the latest supply shock. The question for policymakers is whether to tighten further to anchor expectations or to hold fire and absorb the hit to growth.

Why the ECB is likely to wait until June

At its March meeting the ECB kept rates steady, and Christine Lagarde, the bank's president, said the governing council was ready to hike even if the coming inflation spike proved temporary. That language was widely read as a signal that a move was coming soon. Since then, however, the data have evolved. Oliver Rakau, chief Germany economist at Oxford Economics, argues that energy prices are not far enough above the ECB's own forecast assumptions to force an immediate reaction, and that diplomatic talks between Washington and Tehran keep alive the possibility of a short conflict. Surveys also point to a more front-loaded economic hit than in 2022, which dampens the risk of second-round effects, the wage and price spirals that are far harder to reverse.

Rakau expects the ECB to hold this week but to lay the groundwork for a 25-basis-point increase in June, taking the deposit rate to 2.25%, followed by another in July. That path, he says, balances the economic cost of tighter policy against the need to cap second-round effects. BNP Paribas economists agree that an April hold does not mean a response is unnecessary, only that there is insufficient data to justify it today. They see the June meeting as the live one, provided energy prices do not fall sharply, which is not their central case. The governing council will want to preserve full optionality, they note, and is unlikely to pre-commit to a hike or signal a strong bias. Recent communications have struck a slightly less hawkish tone, emphasising that the bank is well positioned to wait and see.

Bank of England faces a tighter split

The BOE's monetary policy committee meets on the same day. In March the bank said inflation was now likely to peak between 3% and 3.5% in the second and third quarters of 2026, driven by higher energy prices, but cautioned that uncertainty over the war made predictions tricky. Before the conflict, a series of rate cuts had been expected this year. Those expectations have evaporated. A Reuters poll of economists last week showed a majority now expect the BOE to keep rates unchanged for the rest of 2026, arguing that policymakers will choose to look through the inflation spike caused by external factors. The committee will also be wary of encouraging stagflation if they raise rates while growth is weakening.

For Thursday's meeting, the consensus points to an 8-1 vote in favour of holding, with Huw Pill, the chief economist and a known hawk, the sole dissenter favouring a hike. Morgan Stanley's Bruna Skarica and Fabio Bassanin say markets will be looking for simple communication and a clear strategy. The dilemma, they write, is not whether inflation will rise following the commodity uptick, but whether tightening to ensure a swifter return to the 2% target would be worth the estimated loss in growth. Suren Thiru, chief economist at ICAEW, calls a hold a near certainty and warns that stagflation fears will cast a long shadow over the meeting. The squeeze on demand from weakening wage growth and a slowing economy, he adds, should give policymakers sufficient wriggle room to keep rates on hold through this period of elevated inflation.

Second-round effects remain the central worry

The term stagflation, slow growth, high inflation, rising unemployment, has returned to the lexicon. What makes it dangerous for central bankers is the feedback loop: a supply shock pushes up prices, workers demand higher wages to compensate, firms raise prices again, and inflation becomes embedded. That is what happened in the 1970s and, to a lesser extent, after the 2022 energy crisis. The ECB and BOE are both watching closely for signs that inflation expectations are de-anchoring, that wage growth is accelerating, or that firms are passing through costs more aggressively. So far, the evidence is mixed. Rakau notes that the bar for ECB action is low: rising inflation expectations, a resilient labour market, contained economic damage and accelerating core inflation would together trigger hikes. But the data needed to show sufficient evidence of second-round effects have not yet arrived.

Jose Garcia Cantera, chief financial officer of Santander, told CNBC that central banks are taking a pause and that any higher rates in Europe will be very moderate. He credited the ECB with doing a great job of containing inflation, suggesting the trend means the need for higher rates will be modest. That view aligns with the market pricing, which has pared back the aggressive hike bets seen in early March. The challenge for both institutions is to communicate that patience is not complacency, that they are ready to act if the data warrant it, but will not overreact to a supply shock that may prove transient.

Communication challenges and market expectations

Forward guidance has become a delicate exercise. The ECB's governing council will want to avoid boxing itself in. BNP Paribas expects the bank to emphasise optionality rather than a pre-commitment, consistent with the slightly less hawkish tone of recent communications. For the BOE, the task is to explain why a 3.3% inflation rate does not demand an immediate response when the mandate is 2%. The answer lies in the origin of the shock: external energy prices, not domestic demand. Raising rates cannot lower the price of oil or gas, but it can deepen a recession. That is the stagflation trap. Morgan Stanley's analysts expect the BOE to highlight caveats around acting in a manner that takes into account the impact of tighter policy on growth, a more prominent role for growth considerations than in March.

Financial markets have adjusted. Short-term interest rate futures now imply a high probability of an ECB hike in June and a low probability of any BOE move before 2027. The euro has been relatively stable against the dollar, while sterling has softened as rate-cut expectations for later in the year have been pushed out. Bond yields have risen at the long end, reflecting both inflation risk and the prospect of higher-for-longer policy. The ECB's own press conference on Thursday will be parsed for any shift in language around the inflation outlook, the growth forecast, and the reaction function.

What the data must show before a move

Both central banks have set implicit thresholds. For the ECB, the June meeting is the hinge. A 25-basis-point hike to 2.25% is the base case for many economists, but it depends on the May and June inflation prints, the next round of wage data, and the evolution of the conflict. If energy prices retreat or a ceasefire takes hold, the case for tightening weakens. If core inflation accelerates and wage settlements surprise to the upside, the case strengthens. The BOE's threshold is higher: with growth already slowing, the MPC needs clearer evidence that second-round effects are taking hold before it risks a hike. The 8-1 split expected this week may not hold if inflation proves stickier than forecast or if the labour market remains tighter than anticipated.