ECB, Bank of England Set to Hold Rates Unchanged Today

The ECB Awaits Further Information Before Deciding on the Direction of Rates

The Iran war has not broken the euro area economy—but it has bent the trajectory in a more risky direction. The shock is not about the current damage necessarily but about what it may set in motion: a renewed energy impulse that risks re-embedding inflation psychology just as it was fading. Headline inflation for the euro area edged up to 3.0% year-over-year in April, from the 1.9% as of February of this year before the Iran war broke out (Figure 1). This was even as core price rises stayed well anchored – slightly easing to 2.2% year-on-year this month.

Figure 1. Euro area headline inflation has edged up, even as core price rises remain well anchored to date

Euro area headline and core harmonised index of consumer prices, annual rates of change, %

Growth has felt the drag through both confidence and real incomes, with the euro area composite purchasing managers’ survey shrinking in April – for a first time since 2024.

A core focus of policy makers remains rightfully on expectations—once households and firms begin to believe inflation is back, they behave in ways that make it so. As Brent crude prices stay above USD 100 a barrel, there are signs of increasing inflation expectations in gauges of households and firms. In that sense, the war’s effects may be the most apparent in a shifting balance of risks: away from disinflation, and back toward persistence. We are likely operating already somewhere between a benign baseline scenario of the European Central Bank and an adverse scenario of the Bank—and within that grey zone, the asymmetry is clear: growth risks skew down, inflation risks skew up.

As I recently commented for a Bloomberg panel of economists – the ECB’s threshold for eventually responding may be lower than it may appear to many. The next move in official rates is more likely to be a hike than a cut, even if conditions remain fluid. It does not require the proof of a wage spiral; it only needs a credible risk of one. Even though a relatively benign path—whereby inflation expectations stay broadly anchored—would not necessarily compel tightening on its own, the ECB may nevertheless choose to act even under such a scenario to protect credibility if the persistence risks linger. ECB President Christine Lagarde said last month that policy makers were ready to raise rates even if an increase in euro area inflation were to prove temporary.

A 25bp “insurance hike” by the summer may fit such a playbook: cautious in size, but decisive in signal. This would be policy aimed less at today’s reality than at tomorrow’s regret—the cost of doing too little being judged higher than the cost of doing slightly too much—especially following the late response following the 2022 energy crisis. And crucially, such a bias to hike may hold even if a fragile US–Iran ceasefire hypothetically holds: the ECB would still be managing the aftershocks in expectations, not just the headlines.

Moderate rate increase(s) would target ensuring inflation expectations stay firmly anchored and trimming second-round effects, while restricting the damage to the economy and the labour market. At the same time, the ECB may shy from fulfilling present market expectations pricing three 25bp hikes before the year is out less elevated energy prices more meaningfully de-anchor expectations.

The Bank of England on Hold for the Moment

The Bank of England looks similarly set to hold rates unchanged at its meeting today, sticking to a wait-and-see stance as it navigates an increasingly uncertain inflation backdrop. That said, the calm may prove temporary. The Bank is likely to repeat that it stands ready to act against the threat from persistently elevated inflation.

Inflationary pressures are likely to intensify during the months ahead, driven by the fallout from the Iran war as higher food and fuel costs feed through to households. At the same time, increasing services inflation and an expected pick-up in wage growth from second-round effects risk undoing some of the recent disinflationary progress. Bank projections from March that inflation is to peak between 3% and 3.5% over the second and third quarters of this year may easily see further upside. Increases in inflation could potentially nudge policymakers back towards tightening.

Even then, any rate rises from the Bank may be less likely to live up to money-market expectations of three 25bp hikes over the remainder of 2026. A tepid UK labour market may help to curtail the feedback loop in prices that dogged the Bank after the 2022 energy crisis. Bank of England policy makers know that the UK economy rests on a fragile footing – especially given the long-standing vulnerabilities to increases in energy prices. In addition, with higher market yields already doing much of the tightening for it, the risk of going too far is very real.

If the bank rate does rise later on this year, it is more likely to be a cautious recalibration from the Bank than the start of any full-blown “hiking cycle”. The Bank is, in effect, walking a policy tightrope — caught between persistent inflation on the one side and a softening growth outlook on the other.

Dennis Y. Shen is a macroeconomist and the former Chair of the Macroeconomic Council of the European credit rating agency. He is a lecturer in finance at the International School of Management (Germany) and serves as a Member of the Supervisory Board of Visioneers gGmbH. He is a regulator contributor for the London School of Economics.