European Central Bank in ‘wait-and-see’ mode on interest rates

All eyes will be on Europe’s central banks this week as they announce their latest monetary policy decisions against a backdrop of rising prices and growth concerns.

Eurozone and UK figures for March show the Iran conflict is already weighing on the economy, raising fears of looming “stagflation” with low growth, high inflation and rising unemployment.

The ECB and BOE kept interest rates on hold in March as the war began to shake up the global economy, but both are expected to take a cautious approach on Thursday.

Markets quickly began pricing in interest rate hikes by the two central banks in the wake of the Iran conflict, but economists now believe policymakers have picked up on the “noise” surrounding soaring inflation and will keep rates at 2% for the ECB and 3.75% for the BoE for an extended period of time.

The decision comes as inflation in the euro zone stands at 2.5% and in the UK at 3.3%, both above the banks’ 2% target.

“Energy prices are not well above the ECB’s forecast assumptions, but attempts at negotiations between the US and Iran continue to assume a short-term conflict,” Oliver Rakau, Germany’s chief economist at Oxford Economics, told CNBC in an emailed comment.

“The survey also suggests that the economic shock will occur earlier than 2022, undermining concerns about the impact of a second wave,” he said.

Secondary effects refer to the more indirect effects of sudden inflationary shocks, such as workers demanding higher wages or businesses raising prices. These are often more ‘sticky’ and prove difficult for central bankers to quell through monetary policy decisions.

Rakau added that data would need to show sufficient evidence of the effectiveness of the second wave to prompt ECB action, but the bar was low.

“We expect signs of rising inflation expectations, resilience in the labor market, containment of economic damage, and acceleration in core inflation to trigger rate hikes in June and July,” he said. “This gradual tightening balances the economic costs incurred and the ECB’s objective of containing second-order effects.”

The ECB’s forward guidance will continue to be closely watched on Thursday. ECB President Christine Lagarde said at the central bank’s last meeting a month ago that policymakers were prepared to raise interest rates even if the expected rise in eurozone inflation turns out to be temporary.

Economists say the central bank’s June meeting will be a closely watched meeting and could see it raise the key interest rate by 25 basis points to 2.25%.

The ECB Governing Council wants to give itself “full option to raise interest rates at its next meeting if the data warrant,” economists at BNP Paribas said in an email analysis ahead of the meeting.

“A stay in April therefore does not necessarily mean no action is needed, just that there is not enough data to justify a decision at this time. Unless energy prices fall significantly and sustainably in the near term, which is not our core case, we ultimately expect the data to support a 25bp rate hike at the June meeting.”

However, BNP Paribas does not believe the ECB will pre-commit to rate hikes or signal a strong bias towards such an outcome. “Instead, it is likely to emphasize that it is ‘in a good position’ to take a wait-and-see approach, consistent with the somewhat less hawkish tone of its recent communications,” they noted.

Santander Chief Financial Officer Jose García Cantera told Squawk Box Europe on Wednesday that he does not expect interest rates on the continent to rise significantly anytime soon.

“Central banks are on pause. They are considering raising interest rates in Europe, but very gradually,” he said. “[The ECB]is doing a great job of controlling inflation, and this trend will probably mean that the need to raise interest rates will be very moderate.”

The BOE’s prediction that inflation would begin to cool toward its 2% target was overturned when the Iran war began in late February.

The bank said in March it expected inflation would likely peak between 3% and 3.5% in the second and third quarters of 2026 due to rising energy prices, but warned that uncertainty surrounding the war made predictions difficult. The latest data showed inflation rose to 3.3% in the 12 months to March, up from 3% the previous month.

A series of rate cuts had been expected in 2026, but the outbreak of war reversed those expectations as expectations for rate hikes this year.

But those hopes have waned, with economists now expecting a majority of the BoE’s nine-member Monetary Policy Committee (MPC), led by Governor Andrew Bailey, to take a very cautious stance on monetary policy.

A Reuters poll last week found a majority of economists expected the Bank of England to keep interest rates on hold for the rest of the year, insisting that policymakers would choose to “wait out” any spikes in inflation caused by external factors. BOE rate setters will also be wary of fueling “stagflation” if they raise interest rates.

For this week’s meeting, a majority of economists expect an 8-1 split in favor of keeping rates on hold this month, with BOE hawks and Chief Economist Hugh Pill expected to be the only opponents of support for raising rates. Morgan Stanley’s chief UK economist Bruna Scalica and strategist Fabio Vasanin said the market wanted simple communication and clear strategies from banks.

“In terms of messaging, it is hard to see anything other than guidance for potential actions if the risk of a second round effect increases. We envisage a more prominent role for warnings about acting in a way that takes into account the impact of tighter policy on growth than in March,” they said in an emailed analysis ahead of the vote.

“The question is not whether inflation will rise as a result of the sharp rise in commodity prices. The dilemma is rather whether policy tightening to ensure an early return to the 2% target is worth the estimated growth losses,” the analysts said.

Suren Thiru, chief economist at ICAEW, said policy appeared almost certain to remain in place.

“Stagflation concerns will cast a long shadow over this policy meeting, raising concerns about inflation and potentially causing at least one hawkish rate setter to break ranks and vote to raise rates,” he added.

“Policy development is likely to become more risky for committee members, especially given the growing global headwinds.”

Thirou added: “Slower wage growth and a weaker economy will weigh on economic demand, giving policymakers plenty of room to keep interest rates on hold through this period of high inflation.”