• Sentiment may have improved on comments from the US administration, but energy-driven stagflation risks remain elevated with oil holding around the 90 USD/bbl mark. We maintain our initial view that the conflict will last a matter of weeks rather than months, but even under a de-escalation scenario we expect energy prices will reflect a persistent risk premium.
• That shifts the European inflation outlook higher with headline rates set for a moderate overshoot in 2026. Central banks would typically try to look through this sort of supply shock, but after 2021-22 greater weight will inevitably be placed on household inflation expectations and the risks of second-round effects.
• Recent ECB comments have reinforced the sense that a hike is conceivable, but it is not yet our base case. Officials should be able to tolerate a small inflation overshoot. But the ECB has already brought rates back to neutral, which may make it harder to stand pat compared to other central banks – especially in the case of rising household inflation expectations and resilient growth.
• In the UK, BoE policy is still (mildly) restrictive which gives more licence to be patient. Officials will likely sit tight and defer any shift in thinking to April. A cut then is not completely out of the question, but it would likely require credible geopolitical de-escalation and further signs of labour market softness. We maintain our base case for two more cuts for now, but there are obvious risks around the timing and extent of further easing. Many BoE officials are wary of sticky household expectations and the risk of a structural shift in price-setting processes. Bailey’s view on the risks around this will remain key on a divided MPC.

Hawkish repricing reflects renewed concerns around structural shifts in price-setting

Risk sentiment improves but European stagflation risks remain elevated

Hopes for de-escalation in the Middle East were boosted by comments from Trump saying that he expects the conflict with Iran to be resolved “very soon” and that his administration’s military objectives are “pretty well complete”. The timing of Trump’s comments suggests sensitivity to market stress after oil surged to 120 USD/bbl at the start of the week.

While these developments support our initial view that the conflict is more likely to last a matter of weeks rather than months, there is still little clarity about the US medium-term strategy or Trump’s ability to control developments. Iran opted for continuity by picking Mojtaba Khamenei as its new supreme leader and officials have indicated that the country is not seeking a ceasefire. It is very plausible that decentralised groups will continue to pose a threat to shipping in the Strait of Hormuz. The Israeli government’s objectives may also differ to those of the US. Against that backdrop, oil remains around the 90 USD/bbl mark (~50% YTD), despite the proposed release of strategic reserves.

The situation is clearly fluid and any inflation projections at this stage must be taken with a pinch of salt. But we judge that a tentative de-escalation scenario with high uncertainty and risks around sporadic disruption to shipping and production could see oil remain around the 75-80 USD mark for an extended period. In that case, and assuming a similar profile for European gas and lagged effects through e.g. food prices, we would likely lift our 2026 euro area HICP projection from 1.8% (pre-conflict) to around 2.3%. In other words, the outlook flips from a small undershoot to a moderate overshoot. It would be a similar story in the UK with CPI closer to 3% this year (our pre-conflict projection was 2.4%).

In terms of risk scenarios, we believe that headline inflation rates could peak above 5% in both the euro area and UK in an adverse scenario of oil at 120 USD/bbl and natural gas at 100 EUR/MWh, provided that sort of pricing is sustained and combined with supply chain disruption, weaker currencies and minimal government intervention.

Policymakers will be mindful of second-round effects

The marked increase in European inflation risks is certainly being reflected in markets. At the time of writing, ~35bp of ECB tightening is priced this year. Lagarde said that that the ECB will do “all that is necessary to ensure inflation is under control” with other officials echoing the idea that the ECB would at least consider raising rates. Meanwhile, BoE rate cuts have been all but priced out.

In an ideal world, central banks would feel comfortable looking past this type of supply-side inflation shock, which only directly lifts inflation rates for a limited period and will weigh on economic activity. But we do not expect to hear the word ‘transitory’ used this time with the 2021-22 surge in inflation still fresh in memories. Household inflation expectations have drifted lower since that episode but cannot be considered ‘well-anchored’. Energy prices are a strong reference point for consumers and policymakers will worry that expectations could become further dislodged, causing spiralling cost pressures.

For now, policymakers will be in no rush to change course while uncertainty remains elevated. Eight G10 central banks will meet next week – we expect the broad message will be “wait and see”. (We set out our current thoughts on the ECB & BoE outlook below and will publish full previews ahead of next week’s meetings).

The intention to preserve flexibility is understandable but higher energy prices will mechanically and quickly lift inflation rates. If higher energy pricing is sustained, officials will have to decide how much weight they place on household inflation expectations (which will rise) relative to labour market and demand dynamics (which will weaken).

There will also be uncertainty around the fiscal response, with governments also in ‘wait and see’ mode. Energy support measures can be rolled out quickly, especially since templates will be there from the previous crisis, but competing fiscal demands (e.g. for higher defence spending) could limit governments’ room for manoeuvre.

Energy prices have surged on geopolitical developments...

...triggering a sharp repricing in policy expectations in Europe

The historical context supports a cautious approach

The long-term context adds to the case for caution. It was a hard slog for central banks to bring inflation and expectations under control. Credit is due to policymakers for navigating the 2021-22 price shock relatively successfully. Euro area inflation has now been well-behaved for an extended period, and the UK story would look better if not for government policy on employment costs. But monetary policymakers will now be mindful of undoing the hard work of their predecessors by allowing a structural shift in household expectations.

We think officials will be at least somewhat more worried about inflation risks (i.e. unanchored expectations) and less worried about recession risks than last time. But there will also be awareness that the backdrop in 2021-22 was different with labour shortages, fragmented global supply chains, recovering post-pandemic demand with high levels of household saving, and strong fiscal stimulus (especially in the US). The obvious risk is that central banks re-fight the last battle and place too much weight on household expectations in a different macro backdrop.

The bottom line is that the stagflation risk is real and immediate and that will not be easy for policymakers to navigate. Concerns around structural shifts in expectations may become harder to ignore and rate hikes have suddenly become plausible (but are not our base case – see below).

Household inflation expectations remain somewhat elevated

The long-term picture supports a cautious approach

ECB and BoE – Our current views

ECB: A hike is conceivable but not yet our base case

• Our initial take was that developments last week meant the ECB was essentially even more ‘on hold’ (see here). Unchanged policy remains our base case, on the assumption of credible de-escalation in the Iran conflict over coming weeks and annual inflation this year rising to a tolerable ~2.3%.
• The ECB’s previous inflation outlook was for a small undershoot. Policymakers made it clear that this is acceptable, and the same should apply in the case of a mild overshoot.
• But a hike this year is conceivable with recent comments from officials suggesting a willingness to adapt the current stance if required. Prior to the conflict, we saw risks being tilted to a downward ‘calibration’ on rates. By the same logic, a hike is conceivable if higher energy pricing is maintained and the inflation outlook flips to a more meaningful overshoot. The bar is higher – tightening into a supply shock would have greater credibility risks attached than extending the previous easing cycle.
• The ECB has already brought rates back to neutral, which may make it harder to stand pat compared to other central banks. Policymakers could lose their nerve and raise rates if inflation were to move above 2.5%, say, and household expectations were to rise – especially if growth remained broadly resilient. Remember, German fiscal support is starting to come online and will provide a cushioning effect.
• A weaker EUR (see here) could support export demand but won’t help with price pressures. It’s worth also mentioning that the scope for trade diversion to weigh on inflation (which we had held up as a factor that skewed risks dovishly) has been reduced post-IEEPA ruling (see here).

BoE: Risks of second-round effects support a more cautious approach to further easing

• The BoE will adopt a ‘wait and see’ stance and almost certainly leave rates unchanged at next week’s policy meeting. We expect a relatively united decision. We have pencilled in an 8-1 split in favour of no change, with just one dissent for a cut. It feels too soon for any hawks to break cover and push for a hike.
• The BoE has more license than the ECB to take a patient and passive approach given that rates are currently in (mildly) restrictive territory. The UK’s energy price-cap system will also shield consumers initially with recent moves in wholesale gas prices only set to show up in Ofgem’s cap from July. There have also been some indications from the Chancellor that fiscal policy interventions could offset the inflationary impact of higher energy prices.
• Labour market slack in the economy will also remain relevant (see here) and geopolitical uncertainty is likely to be another headwind to hiring, at the margin. Our pre-conflict call was for two more cuts to a terminal rate of 3.25% and we maintain that view going into the next meeting, while acknowledging the obvious risks around the timing and extent of further easing.
• We still see some scope for an April cut, but it would require credible geopolitical de-escalation between now and then, as well as more soft labour market numbers (the next batch of figures will be released next week).
• UK policy uncertainty remains high given the fragmented nature of the MPC. Governor Bailey’s views remain key. There is a strong hawkish contingent which has previously highlighted the risks around possible structural changes in price and wage-setting behaviour. How Bailey frames the discussion on household inflation expectations has potential to strongly influence market expectations.

   We will release full previews for both the ECB and BoE ahead of next week’s meetings.