Europe’s central banks in ‘wait-and-see’ mode on interest rates

European central banks are in focus this week, as the European Central Bank and the Bank of England announce their latest monetary policy decisions amid rising prices and growth fears.

March data from the Eurozone and the UK shows that the conflict in Iran is already putting pressure on economies and triggering fears of “stagflation” – slow growth, high inflation and rising unemployment.

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

Markets quickly began pricing in interest rate hikes from both central banks following the outbreak of the Iran conflict, but economists now think policymakers will take into account the “noise” around rises in inflation and keep interest rates steady for longer at 2% for the ECB and 3.75% for the BOE.

The decisions were taken because inflation was 2.5% in the Eurozone and 3.3% in the UK, above the banks’ respective 2% target.

“With energy prices not sufficiently above the ECB’s forecast assumptions, attempts at negotiations between the United States and Iran remain biased towards the assumption of a short conflict,” Oliver Rakau, Chief Economist for Germany at Oxford Economics, told CNBC via email. he said.

“Surveys also point to a more front-loaded economic hit compared to 2022, reducing concerns about second-round effects,” he said.

Second-round effects refer to the more indirect consequences of sudden inflation shocks, such as workers demanding higher wages and firms increasing prices. These often prove to be “stickier” and harder to suppress with central bankers’ monetary policy decisions.

Rakau added that the data must show enough evidence of second-round effects to prompt the ECB to act, but the bar is low.

“We expect signs that rising inflation expectations, a resilient labor market, containment of economic damage and an acceleration in core inflation will trigger interest rate hikes in June and July,” he said. “This moderate tightening balances the economic costs imposed and the ECB’s aim to limit second-round effects.”

The ECB’s forward guidance will be closely monitored on Thursday, as usual. European Central Bank President Christine Lagarde said at the bank’s last meeting a month ago that policymakers were ready to raise interest rates even if the expected rise in euro zone inflation turned out to be temporary.

Economists say the bank’s June meeting will be the one to watch and a 25 basis point increase could take the key interest rate to 2.25%.

The ECB’s governing council would want to have “full optionality to raise interest rates at the next meeting if the data warrants it,” BNP Paribas economists said in an emailed analysis ahead of the meeting.

“Therefore, a hold in April does not necessarily mean that a response is not necessary, it just means that there is not enough data to justify the decision at this time. Unless there is a significant and sustained decline in energy prices in the near term (which is not our main case), we ultimately expect the data to support a 25 basis point rate hike at the June meeting.”

However, BNP Paribas does not think the ECB will pre-commit to a rate hike or have a strong bias towards such an outcome. “Instead, recent communications are likely to emphasize that we are ‘well positioned’ to wait and see, consistent with a slightly less hawkish tone,” they said.

Santander CFO Jose Garcia Cantera told Squawk Box Europe on Wednesday that he did not expect to see significantly higher rates on the continent anytime soon.

“Central banks are pausing. They are looking for higher rates in Europe, but they are very moderate,” he said. ” [ECB] “It’s been doing a great job of keeping inflation under control, so this trend will probably mean that the need for higher rates will be very modest.”

The start of the Iran war at the end of February raised the BOE’s forecasts that inflation would cool towards its 2% target.

The bank said in March that inflation was expected to peak between 3% and 3.5% in the second and third quarters of 2026 due to high energy prices, but warned that uncertainty about the war made forecasts difficult. Latest data showed Inflation rose to 3.3% in the twelve months to March, up from 3% recorded the previous month.

majority Economists surveyed by Reuters They said last week they expected the BOE to keep interest rates unchanged for the rest of the year and suggested policymakers would choose to “examine” the rise in inflation caused by external factors. The BOE’s rate setters will also avoid encouraging “stagflation” if they raise rates.

While the majority of economists at this week’s meeting expect an 8-1 split in favor of keeping rates steady this month, BOE Hawk and Chief Economist Huw Pill are expected to be the only dissenters opposing a rate hike. Morgan Stanley’s UK Chief Economist Bruna Skarica and Strategist Fabio Bassanin said markets would be looking for simple communication and a clear strategy from the bank.

“In terms of messaging, it is difficult to see anything other than guidance on potential action should risks of a second-round impact increase. We are taking a more prominent role than in March in warnings about acting to take into account the impact of tighter policy on growth,” they said in analysis emailed before the vote.

“The question is not whether inflation will rise on the back of a sharp rise in commodity prices. The dilemma is rather whether tightening policy to ensure a quicker return to the 2% target is worth the projected losses in growth,” analysts said. he said.

ICAEW chief economist Suren Thiru said it looked almost certain that policy would be kept steady.

“Stagflation fears, along with growing concerns about inflation, will cast a long shadow over this policy meeting, likely prompting at least one of the more hawkish rate setters to break ranks and vote to raise rates,” he added.

“Policymaking is likely to become more precarious for committee members, especially given increasing global headwinds.”

Thiru added: “Weakening wage growth in the economy and contraction in demand due to the slowing economy should give policymakers enough leeway to keep interest rates steady during this period of high inflation.”