When the policy making council of the European Central Bank (ECB) gathered on Thursday morning, the price of a barrel of Brent crude oil was over $125, the highest since 2022. By the time the meeting had concluded, it had fallen by $10 a barrel, as traders wondered whether they had overreacted to the latest developments in the Iran war.
It is a difficult environment in which to make interest rate decisions. Like the Bank of England and the US Federal Reserve, the ECB understandably decided to keep interest rates on hold, for now at least. So far inflation rates have risen, but not by too much – the uncertainty surrounds what can be expected in the months ahead.
Some interest rate increases can be expected, certainly from the ECB, which could move as soon as next month. While this will have no impact on energy costs, the theory is that it can slow inflation spreading more widely through the economy and send an important message to households and businesses. Having been criticised for being too slow to increase interest rates in 2022, the ECB is not likely to hold off too long this time.
Higher interest rates put pressure on borrowers. But of course the key question is the scale of the likely rise. Financial markets reckon that the ECB could push up interest rates twice, or at most three times this year, probably by a quarter point each time. The so-far unanswered question is what might happen after that. If oil prices start to edge back, then the scale of increases would be nothing like late 2022 and 2023, when ECB rates rose by four percentage points in total.
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The ECB is right to hold fire for now, given the uncertainties and the weak state of the euro zone economy. It may well want to send a signal next month through a small increase, but beyond that it faces a difficult balance.
The combination of lower growth and higher inflation threatened by higher energy costs makes the calculation for central banks difficult and risky. A lot hangs on whether a way can be found to open the Strait of Hormuz in time to see energy costs heading lower over the rest of the year.
