Middle East conflict elevates inflation risks for Europe
The Central Bank of Ireland (CBI) highlights that the Middle East conflict significantly increases near-term inflation risks and dampens growth prospects for Europe. This new uncertainty led the ECB Governing Council to hold its main policy rate unchanged at its latest meeting.
Energy shock reshapes inflation and growth outlook
The Middle East conflict fundamentally alters both supply and demand drivers for inflation and growth.
On the supply side, it immediately pushes energy prices higher, increasing the risk of headline inflation moving above target faster than anticipated.
Sectors heavily reliant on energy, such as fertilizer production, are also likely to experience cost-push inflation.
The March projections now forecast oil and gas commodity price increases of 18 percent and 28 percent respectively for 2026, a significant reversal from December's expected declines of 10 percent and 19 percent.
Demand-side impacts, affecting real incomes, investment, confidence, and global trade, are slower-moving but create a growth headwind.
The Governing Council considered adverse scenarios where energy prices could peak at double or triple end-2025 levels.
While direct pass-through to headline inflation is limited, indirect and second-round effects from rising input costs and wage adjustments are expected.
Patience guides policy amid dual pressures
Given the upward and downward price pressures, combined with significant uncertainty, the Governing Council decided to wait for more clarity on the outlook.
This led to the main policy rate remaining unchanged at its latest meeting, with a commitment not to pre-commit to a particular rate path.
This is the second energy supply shock in five years, following the Russian invasion of Ukraine.
However, key differences exist compared to 2022: last month's headline inflation was 1.9 percent (compared to over 5 percent pre-invasion), the labor market is closer to pre-pandemic levels, and monetary policy is currently within the neutral rate range, unlike the exceptionally accommodative stance of minus 0.5 percent in June 2022.
Inflation expectations also remain anchored at the 2 percent target.
Uncertainty demands vigilance
The current situation clearly shifts inflation risks to the upside in the near-term, while growth risks lean to the downside.
Although monetary policy cannot prevent the initial energy shock from impacting prices, it is crucial to ensure this remains a one-off adjustment in living costs.
The determination to deliver the 2 percent medium-term target requires heightened vigilance against complacency and potential disanchoring of inflation expectations.