ECB signals rate hike readiness even for temporary inflation spike from Iran war

The European Central Bank has moved a step closer to tightening policy again, with President Christine Lagarde telling an audience in Frankfurt that policymakers would consider raising interest rates even if the inflation surge triggered by the Iran conflict proves short-lived. Speaking at the ECB and Its Watchers conference on Wednesday, Lagarde argued that a "not-too-persistent" overshoot of the 2% target could still warrant a "measured adjustment", a formulation that marks a noticeable shift from the bank's recent emphasis on patience and data dependence.

The communication dilemma

Lagarde's reasoning was explicitly reputational. "To leave such an overshoot entirely unaddressed could pose a communication risk: the public may find it difficult to understand a reaction function that does not react," she said. The passage, delivered without a timeline or explicit criteria for action, frames a potential hike as much about credibility management as about the mechanical transmission of higher rates to the economy. It also underscores how the ECB's own forecasting framework has been upended in the space of a few weeks.

Before the Iran conflict erupted in late February, euro area headline inflation had dipped below the 2% target. The February flash estimate from Eurostat put the rate at 1.9%, the first sub-target reading since mid-2021. Tehran's retaliatory blockade of the Strait of Hormuz, through which roughly a fifth of global oil supply passes, has since sent Brent crude above $95 a barrel and Dutch TTF gas futures to levels not seen since the winter of 2022-23. The ECB's March staff projections, published alongside the decision to hold the deposit rate at 2%, now show baseline inflation averaging 2.6% this year, 2% in 2027 and 2.1% in 2028.

Three scenarios, one direction

The projections come with two alternative scenarios that illustrate the asymmetry of the risk. In an "adverse" case, where energy prices remain elevated but Gulf infrastructure is largely intact, inflation peaks at 4% in 2026. In a "severe" case, assuming a stronger and more persistent energy shock and further significant destruction of Gulf production and export capacity, the peak exceeds 6% early next year. Both alternatives keep inflation above target for longer than the baseline, and both would, in Lagarde's formulation, demand a response that is "appropriately forceful or persistent".

The ECB's governing council has not voted on a hike since September 2023, when it took the deposit rate to 4% before beginning a cutting cycle that brought it to 2% by June 2024. The March 2025 meeting, the most recent before Wednesday's remarks, left rates unchanged. Money markets had, until the Iran escalation, priced a high probability of a further cut to 1.75% by mid-year. That pricing has now reversed: overnight index swaps imply a roughly 60% chance of a 25 basis-point increase by September, with the first full hike not fully priced until the fourth quarter.

Lane watches wages and pricing power

Chief Economist Philip Lane, speaking separately on Wednesday, spelled out the transmission channels the ECB will monitor. Companies' price-hike expectations and wages for new hires, he said, are among the key indicators for second-round effects. The distinction matters: the ECB's models treat energy-driven inflation as a first-round shock that should fade unless it feeds into wage-setting and margin expansion. Lane's emphasis on new-hire wages, a leading indicator of labour cost momentum, suggests the bank is watching for signs that the shock is embedding itself in the domestic cost structure before it has fully passed through consumer prices.

Early evidence is mixed. The ECB's own Survey on the Access to Finance of Enterprises for the second half of 2024 showed that while energy-intensive firms reported rising cost pressures, the median firm still expected selling-price increases below 2% over the coming year. Negotiated wage growth in the euro area ran at 3.8% year-on-year in the fourth quarter of 2024, according to the ECB's negotiated wage tracker, down from a peak of 4.7% in mid-2023 but still above the rate consistent with 2% inflation over the medium term given trend productivity growth of roughly 0.5%.

Real economy already feeling the pinch

The shock is not waiting for the second round. S&P Global's flash composite purchasing managers' index for the euro area fell to 48.7 in March from 50.2 in February, the first contraction since May 2024 and the lowest reading in ten months. The manufacturing index dropped to 46.1, services to 49.3. Input cost indices surged across both sectors, while output price indices rose more modestly, squeezing margins. New export orders weakened sharply, a signal that the terms-of-trade deterioration is feeding through to competitiveness.

Germany, the bloc's largest economy and its most energy-intensive, saw the composite PMI fall to 47.4. France held just above the 50 threshold at 50.1, supported by a resilient services sector. Italy and Spain, less exposed to gas-intensive industry, posted shallower declines. The divergence mirrors the pattern of the 2022-23 energy crisis, when German industrial output fell by more than 6% peak-to-trough while southern Europe's service-led economies weathered the shock better.

The fiscal-monetary interface

Lagarde's remarks also land in a changed fiscal environment. Germany's constitutional debt brake was suspended in December 2024 to fund a €200 billion energy-price shield and defence spending package, while France's 2025 budget targets a deficit of 5.4% of GDP. The ECB's pandemic-era PEPP reinvestments end this year, and the transmission protection instrument (TPI) remains untested. A rate hike would raise debt-service costs for highly indebted sovereigns at the moment fiscal policy is expanding, reviving the fragmentation risk that dominated the 2022-23 tightening cycle.

The governing council's next scheduled meeting is 17 April. No new staff projections are due until June. Between now and then, the data flow, April flash inflation on 30 April, first-quarter GDP on 30 April, May PMI on 23 May, will determine whether the "measured adjustment" Lagarde described becomes a concrete proposal or remains a rhetorical device. The council's hawks, led by Bundesbank President Joachim Nagel and his Dutch and Austrian counterparts, have already argued in private that the baseline forecast alone justifies a hike. The doves, including the French, Italian and Spanish governors, contend that the adverse scenario is a tail risk, not a central case, and that tightening would compound the demand destruction already visible in the PMI.