The Iran war is adding to Europe’s central banks rate-decision headaches

Before the war on Iran began in late February, Europe’s central banks enjoyed a more benign inflation outlook as interest rates looked set to remain stable or keep falling across the region.

But the conflict has upset the economic equilibrium, threatening Europe’s energy supplies, growth and the outlook for consumer prices. Expectations for interest rates across the continent have been upended.

On Thursday, the European Central Bank, Bank of England, Sweden’s Riksbank and Swiss National Bank all deliver their latest monetary decisions. Each central bank is also likely to deliver its first comments on how the U.S. and Israel’s war on Iran, which began in late February, is likely to impact their decision-making.

The Swiss National Bank kept its main policy rate on hold at 0.00% on Thursday, with the central bank stating that its “willingness to intervene in the foreign exchange market has increased” in the context of the Middle East conflict.

Doing so, if necessary, would counter any “rapid and excessive appreciation of the Swiss franc, which would jeopardize price stability in Switzerland,” the SNB said.

The war has rendered the economic outlook considerably more uncertain, the SNB added.

“In its baseline scenario, the SNB anticipates that the increase in energy prices will raise inflation in many countries in the short term. Furthermore, global economic growth is likely to temporarily slow somewhat,” the central bank said.

While elevated volatility and aggressive fluctuations in the Swiss franc could increase the scope for foreign exchange intervention, Dani Stoilova, UK and Europe Economist at BNP Paribas Markets 360, said he does “not expect market views on the potential for SNB intervention to meaningfully dampen safe-haven inflows amid geopolitical uncertainty.”

Sweden’s Riksbank also kept its main policy rate on hold at 1.75% at its meeting on Thursday.

The Riksbank said “the rate is expected to remain at this level for some time to come” but cautioned that the Iran war warranted “vigilance.”

While the war in the Middle East makes the forecast very uncertain, the Riksbank said, it will monitor developments closely and will adjust monetary policy if the outlook for inflation and economic activity so requires.

In Sweden, there are fundamentally favourable conditions for the economic recovery to continue, the Riksbank said, with the inflation rate (currently at 1.7%) still below its 2% target.

“Underlying inflation has been unexpectedly low in recent outcomes. The war in the Middle East is expected to dampen growth somewhat in the near term and push up CPIF inflation as a result of higher energy prices. These are also expected to be passed on to some extent to other prices.”

Even before the war began, the ECB was not expected to change its stance on its benchmark interest rate, with euro zone inflation data remaining near the central bank’s 2% target. The latest flash data from Eurostat showed inflation in the euro zone rose to 1.9% in February, up from 1.7% in January.

ECB President Christine Lagarde had, at the central bank’s last meeting in February, repeated a mantra that the euro zone’s economic outlook was “in a good place” but warned against complacency. Her caution now appears to be well-founded.

Traders will pay close attention to ECB guidance on Thursday for clues as to how the bank could respond, as Iran’s closure of the Strait of Hormuz reduces oil and gas supplies to the region, pushing up energy costs and inflationary pressures.

“On Thursday, we expect the ECB to keep the deposit rate at 2% for a sixth consecutive meeting,” Konstantin Veit, portfolio manager at PIMCO, noted this week, adding: “We expect the ECB will stress heightened geopolitical uncertainty and signal a more hawkish tone rather than move policy immediately.”

“In our view, the new staff projections will likely show a short-term inflation overshoot driven by higher energy prices, before inflation returns to 2% next year,” he said, expecting headline inflation to peak at around 3% this year, with energy contributing roughly 1 percentage point.

The Bank of England had been expected to cut its key interest rate, known as ‘Bank Rate,’ at its March meeting, easing pressure households and businesses grappling with high borrowing costs.

But economists say the fallout of the war has left the likelihood of cut increasingly remote. The central bank’s monetary policy committee (MPC) is now likely to err on the side of caution and keep Bank Rate at 3.75% as it waits to see how long the conflict might last.

“The Bank of England is unlikely to surprise this week,” John Wyn Evans, head of Market Analysis at Rathbones, said in emailed analysis.

“Rate cuts once seen as plausible for spring have been fully priced out, and a rise later in the year can’t be dismissed,” he noted. With the duration of the conflict unclear, “the most probable outcome is a holding pattern: not tightening, but certainly not loosening until the fog lifts,” Wyn Evans said.