By Chelsey Dulaney and Paul Hannon
Europe's top central bankers warned that the escalating war in the Middle East would drive up inflation and knock growth.
The conflict is threatening the global economy, but Europe is seen as particularly vulnerable because of its dependence on imported energy. European-natural gas prices have nearly doubled since the conflict began.
"The war in the Middle East has made the outlook significantly more uncertain, creating upside risks for inflation and downside risks for economic growth," ECB President Christine Lagarde said Thursday.
The European Central Bank and its counterparts in the U.K., Switzerland and Sweden all left rates unchanged Thursday. That follows the Federal Reserve's decision to keep rates steady a day earlier. The Bank of Canada and the Bank of Japan have made the same call this week.
Central bankers have stressed that it is too early to say how higher energy costs will affect the economy. But they are beginning to prepare for a longer-lasting disruption to energy supplies that would pose a larger threat.
The BOE signaled it was prepared to raise interest rates to counter the pickup in inflation if it threatened to become persistent.
"I will be monitoring developments extremely closely and stand ready to act as necessary to ensure inflation remains on track to meet the 2% target," said BOE governor Andrew Bailey.
The central bank's latest forecasts show inflation accelerating to 3.5% later this year, instead of returning to its 2% target as previously expected.
The statement sparked a dramatic shift in investors' expectations for the BOE. Investors moved to price in a third interest-rate increase from the BOE after Thursday's meeting. Before the conflict in the Middle East, markets had expected two rate-reductions from the bank this year.
"It has been an exceptionally turbulent day, " said Anna Titareva, an economist at UBS Investment Bank, who thinks the market has overreacted.
"We do not believe in two or more rate hikes this year," she said.
The ECB offered a more balanced assessment of the risks from the jump in energy prices.
That central bank said energy costs would have a "material impact" on inflation and raised its forecast for the year to 2.6% from 1.9%. In a more severe scenario, where energy infrastructure suffers significant damage and supply returns only slowly, inflation could rise toward 5% next year, the ECB said.
But Lagarde also stressed in a press conference that the eurozone economy is coming into the crisis in relatively good shape, with a solid labor market and inflation around its 2% target.
"We are starting from a good base," she said. "We are both well positioned and well equipped to deal with the development of a major shock that is unfolding."
Investors are expecting the central bank to raise rates between two and three times this year, according to LSEG data. Ahead of the conflict, investors had largely expected the ECB to hold rates steady until 2027.
For central bankers in Europe, the key question is how long higher energy costs will last, and what effect they will have on the prices of other goods and services.
The conventional response to a supply shock is to look past it, with the expectation that price surges are often short-lived and that raising interest rates will hurt growth more than help contain inflation.
But European policymakers have been chastened by a sharp rise in energy and food prices following Russia's full-scale invasion of Ukraine in 2022. That led to a jump in wage demands, and higher prices for a range of labor-intensive services. As a result, inflation stayed above their target for longer than they had expected.
They worry that memories of that experience mean workers will be quick to demand higher wages this time around, triggering another round of price rises.
The ECB on Thursday raised its projections for core inflation -- which excludes energy and food prices -- for the next three years, suggesting it does expect the energy crisis to drive up broader price pressures.
"Inflation expectations have a lot to do with the memory that people, corporates have of inflation," Lagarde said. "Now the memory is rather fresh because people have seen inflation."
Write to Paul Hannon at paul.hannon@wsj.com
(END) Dow Jones Newswires
March 19, 2026 14:27 ET (18:27 GMT)
Copyright (c) 2026 Dow Jones & Company, Inc.
