The economist view
Bank of England: Upside inflation risks but deferring a decision
As expected, the Bank of England’s Monetary Policy Committee (MPC) kept rates on hold at 3.75% on Thursday.
The vote was unanimous – all four of those voting to cut rates last month voted to keep rates on hold compared to consensus of a closer 7-2. No members voted for a rate hike at this meeting though. They think (unsurprisingly) that upside inflation risks have risen but the preference was to wait until the next meeting when they would have more information and analysis.
Looking at the views of the four who voted for a rate cut last month – Sarah Breeden, Swati Dhingra, Dave Ramsden and Alan Taylor – the group broadly flagged the significant shift in the outlook for inflation but noted the potential for downside risk to activity. Taylor and Dhingra both highlighted a scenario in which there is a trade-off between inflation and activity, potentially warranting rate cuts later in the year. Taylor was the most dovish of the group saying, “inflation could be higher then lower in the near term … this could imply faster and deeper rate cuts, once inflation risks subside”. He also said he currently sees a “high bar for hiking”.
Governor Andrew Bailey has been the swing voter in recent meetings and felt that a “prolonged disruption to the supply of oil, natural gas and other commodities… increases the upside risk to inflation”. Bailey also noted that the “recent experience of high inflation may also make households and business more sensitive to a new inflation shock”, which could increase the likelihood of second round effects. On the other hand, Bailey acknowledged the current position of the economy may “limit pricing power”.
Unsurprisingly, the Bank of England is focused on upside inflation risk here, but is also alert to some downside risks
The MPC notes that CPI will be higher in the near term as a result of conflict in the Middle East and that the MPC is “alert to the increased risk of domestic inflationary pressures through second-round effects in wage and price-setting, the risk of which will be greater the longer higher energy prices persist”. However, the MPC is also “assessing the implications for inflation of the weakening in economic activity that is likely to result from higher energy costs”.
Quantifying likely near-term inflation boost
The MPC notes that there had only been limited news in the near-term domestic outlook prior to the conflict, but that the conflict would delay the return of inflation to the 2% target. Based on energy prices to 16th March, CPI was now expected to be close to 3½ % in March (almost ½ pp higher than expected in February) and 3% in Q2 rather than the 2.1% previously expected. After higher gas prices also feed through, the MPC thinks CPI could increase back up to 3½% again in Q3. At that point, however, they say that it is too early to judge how large any second-round effects would be.
Medium-term is what matters for policy, though upside risks have risen
For them, “the most important factor in setting policy would be how medium-term inflation was affected by this supply shock”. While assessing a range of risks to medium-term inflation in both directions, it was upside risks that they (unsurprisingly) felt had “increased most notably since February”.
This is a central bank that had been cutting and signalling more cuts were likely. With upside risks inflation having increased, the question is then what they think the appropriate response is.
So, what makes sense for the stance of monetary policy from here?
This is a central bank that had been cutting and signalling more cuts were likely. With upside risks inflation having increased, the question is then what they think the appropriate response is. For now, that seems to be to remain on hold, but they (inevitably?) sound closer to contemplating rate rise than they did before. They agreed that developments over the next six weeks (i.e. until their next scheduled meeting) could shed light on the likely scale and duration of the conflict and early evidence on the “likely propagation of the shock”.
- On the side of remaining on hold: In its deliberations the MPC notes that monetary policy was already somewhat restrictive, the market-implied path for rates had already shifted up and financial conditions had tightened.
- What would lead them to hike? “A larger or more protracted shock, which risked greater second-round effects in wage and price setting, would require a more restrictive policy stance.”
- What would lead them to cut? “Policy would need to be less restrictive if the shock was very short-lived, or if there were to be a larger opening up of slack in the economy that was expected to reduce medium-term inflationary pressures.”
For us that puts the BoE very much in the middle here and likely to remain on hold for a while longer, but with a reasonable probability of a rate hike to mitigate inflation risk as soon as April given the deterioration in the situation in the Middle East over the last day or so. Some of the more dovish members of the committee sound like they might be more open to a rate rise than expected (Dhingra ponders the conditions under which they could hike rates and only Taylor describes a “high bar to hiking”). But an awful lot can change between now and April.
Fed: On hold, hawkish tone
As expected, the US Federal Reserve left rates on hold today. Only Stephen Miran dissented (preferring a cut). Considering how much has happened since the last meeting, the changes to the statement were minimal. The bank inserted a single line referencing the Iran conflict: “The implications of developments in the Middle East for the US economy are uncertain.” There were some changes in the bank’s economic projections from the last set in December, but the median forecast is still for a rate cut this year (with another in 2027). However, for both 2026 and 2027 the median GDP growth and inflation projection has risen, the former reflecting productivity according to Jerome Powell. Unsurprisingly, there is a wider range of forecasts than there was in December for both 2026 and 2027 inflation.
The outlook was uncertain both in terms of how events evolve in the Middle East but also in terms of their effects on the economy.
There was a big focus on uncertainty
Powell uttered the phrase “we’ll just have to wait and see” quite a number of times. The outlook was uncertain both in terms of how events evolve in the Middle East but also in terms of their effects on the economy. He quipped that a number of participants mentioned that if they were ever to skip a forecast round, this would be a good one.
Still, the tone in our view was hawkish. This impression came from a number of things.
- While the median forecast for the Fed funds rate did not change, Powell highlighted that “there was a meaningful amount of movement toward fewer cuts by people.”
- He looked through the latest weak non-farm payrolls and talked about taking January and February together. He mentioned a stable unemployment rate and described the US economy as “doing pretty well.” He said he would be hard pressed to say the labour market objective was more at risk than inflation.
- It isn’t just oil prices that have driven inflation forecasts higher, but also just the feeling – he said – that they haven’t seen the progress they hoped for on core goods, on tariffs.
- He said the question of looking through energy inflation doesn’t really arise until they make the expected progress on goods inflation as the tariff impact fades. And if they don’t see that progress, he said, then we won’t see the rate cut. He said that they must keep what happens to inflation expectations and the broader context of five-years of above target inflation in mind when thinking about whether to look through energy inflation.
- For now, concern felt contained – helped by inflation expectations continuing to look well anchored at the longer term. He said, however, that they worry that repeated inflation shocks can cause trouble for inflation expectations; he said they are very strongly committed to doing what it takes to keep inflation expectations anchored to 2%.
- He did say that there was some discussion that the next move could be a rate hike but said that the vast majority of participants do not see that as a base case (last time he mentioned a rate rise as being nobody’s base case).
Implication for the outlook
Wednesday’s forecasts and press conference underscore that, while it may be reasonable to stick to a central forecast of a rate cut this year for now, that is very much at risk depending how this situation in the Middle East evolves. It also continues to seem unlikely that a rate rise would be on its way any time soon, but neither can one be ruled out in the coming months (especially if inflation expectations give the Fed cause for concern).
ECB: On hold, but ready to respond and leaning towards a hike
As expected, the European Central Bank (ECB) has kept the deposit rate unchanged at 2%. The decision was unanimous. In line with other central banks, the ECB noted that the “war in the Middle East has made the outlook significantly more uncertain, creating upside risk for inflation and downside risks for economic growth”. During the press conference, President Christine Lagarde delivered a calm message and did not convey any urgency around a rate move. However, there was a clear “ready to respond” element to the messaging and an impression of them leaning towards a hike.
1. No longer in a “good place”
According to the statement and reiterated by President Lagarde, they are “well positioned” to “navigate this uncertainty” (in the sense that, inflation is around 2%, inflation expectations are well anchored, the economy has shown resilience of late and interest rates are around neutral at 2%). However, Lagarde was keen to draw a difference with the bank’s previous language. She was not saying that they were “in a good place” (in contrast to earlier meetings). Instead, she said they were both “well positioned” and “well equipped” to deal with the shock unfolding and said they could be agile. Clearly that is a much less “comfortable being on hold” set of wording. “Well positioned”, though, we would see as signalling that they don’t anticipate having to act dramatically given their starting point.
2. Vigilant around second-round effects
There was an underlying message of vigilance. Second round effects from higher oil and gas prices require “close monitoring”. They see risks to growth as on the downside but risks to inflation as on the upside. In terms of exactly what they will be watching, Lagarde talked about the impact of the shock depending on duration, intensity and propagation (indirect and second round effects). To that end, she said that the bank will be particularly attentive to developments in all commodity markets, supply bottlenecks, selling price expectations of firms, all demand indicators, and wage trackers. The bank’s data dependent approach “will help it set monetary policy as appropriate”.
The impact of events in the Middle East was reflected in the ECB staff projections, which included information up to March 11th, a later cut off than usual.
3. Staff forecasts see a return to the 2% inflation target post-shock, but do build in higher interest rates
The impact of events in the Middle East was reflected in the ECB staff projections, which included information up to March 11th, a later cut off than usual. Headline inflation in 2026 has been revised up 0.7pp to 2.6% while economic growth has been revised down 0.3pp to 0.9% in 2026. Core inflation is 2.3% on their 2026 forecast (they have incorporated some indirect and second round effects from higher energy prices into their forecast), but headline inflation is back at the 2.0% target in their central forecast in 2027 and 2.1% in 2028.
Baked into the well-behaved base case medium-term inflation projection, however, are 1-2 ECB rate hikes (since the baseline incorporates market pricing as of March 11th – something Lagarde drew attention to at the end of the press conference in the context of their scenarios – see below). Hence this is a set of forecasts which suggests that if energy prices remain where they are (or where they were on March 11th) they will likely need to raise rates to contain inflation.
4. Their scenarios show much worse outcomes
The staff scenario analysis, look at much worse oil and gas price profiles and more supply disruption than in the baseline. These arguably aligns closer to trends over the past few days in the energy markets than the base case. These scenarios indicate considerable upside risk to inflation, and greater risk that the Euro area will enter a recession. It is important to note that the scenario analysis does not include any monetary or fiscal policy response, which would temper the magnitude of the impacts on inflation somewhat (see below for more details).
Implications for the rate path ahead
All that leaves us assuming that unless things de-escalate soon, there is a good chance that the ECB hike rates by the middle of the year.
ECB scenario analysis: Significant upside risks to inflation if energy prices remain elevated for a prolonged period.
ECB staff have assessed some alternative illustrative scenarios suggesting that a prolonged supply disruption would see inflation above the baseline for the entire forecast horizon. However, the scenarios do not incorporate any monetary or fiscal policy reaction, beyond that already assumed in the baseline. As such, any monetary or fiscal policy response is likely to temper the magnitude of the impact illustrated in these scenarios.
The adverse scenario assumes that in Q2 2026, 40% of oil and LNG flows through the Strait of Hormuz are disrupted, with no major damage to the energy infrastructure, beyond damage that has already occurred (presumably as of March 11th). As a result, the oil and gas prices “peak at USD 119 per barrel and €87 per MWh respectively in the second quarter of 2026, before converging to the baseline assumptions by the third quarter of 2027”. Under this scenario, GDP growth declines to 0.6% in 2026 and 1.2% in 2027, followed by a recovery to 1.6% in 2028. Inflation increases to 3.5% in 2026 (compared to 2.6% in the baseline) but falls back around target beyond 2026.
The severe scenario assumes that in Q2 2026, 60% of oil and LNG flows through the Strait of Hormuz are disrupted, and energy infrastructure damage limits supply capacity. As a result, oil prices “peak at USD 145 per barrel and gas prices at €106 per MWh in the second quarter of 2026, before declining at a much slower pace and remaining significantly above both the baseline and adverse scenario assumptions over the rest of the projection horizon”. In this scenario, GDP growth falls to 0.4% in 2026, recovering to 0.9% in 2027 and 1.9% in 2028. Inflation remains above target for the entire forecast horizon, increasing to 4.4% in 2026 and further to 4.8% in 2027, before falling back to 2.8% in 2028.
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