Middle East conflict puts ECB in tough spot

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The dominant factor determining monetary policy for all major central banks at the moment is the impact of the current conflict in the Middle East on growth and especially inflation. According to the ECB, that shock works mainly through the channel of higher commodity prices, falling real incomes and deteriorating economic confidence indicators. At her press conference, ECB president Lagarde stated that the ECB is currently "well positioned and equipped" to respond to its effects. She referred to the markets' well-anchored inflation expectations for the eurozone and resilient growth, which can increasingly rely on solid private consumption growth. This was the case in the last quarter of 2025, and will continue into 2026, according to the ECB.

ECB in difficult waters

The conflict in the Middle East poses a particular challenge for the ECB, as it does for all central banks. Indeed, the sharp rise in energy prices, together with physical disruptions to trade chains, represent a negative supply shock to the European economy. This is accompanied by downward pressure on economic growth and upward inflationary pressures. Unlike the Fed, the ECB formally has only one policy priority, price stability. If this is met, the ECB will also take economic growth into account.

Unlike demand shocks, supply shocks pose a particular challenge for central banks. The ECB has to assess whether the shock is temporary or longer-lasting. If the shock is temporary and economic agents' inflation expectations remain around 2% over the medium term, the ECB can stay on the sidelines. In the case of a longer-lasting shock, and the risk of rising inflation expectations, the ECB would have to intervene, even if that rate hike would weigh additionally on economic growth. Correctly identifying the supply shock is a particularly difficult task for a central bank, especially in the current environment of exceptionally high uncertainty.  

Dealing with uncertainty: scenario analysis

To deal with this uncertainty, Lagarde presented two alternative scenarios in addition to the base case: an 'adverse' and a 'severe' scenario.

The ECB defines the adverse scenario as an increase in energy prices greater than in the baseline scenario, but those prices fall again to the level of 4 March 2026 over the course of the forecast horizon (2028). In the 'severe' scenario, prices rise more sharply and remain above the 4 March 2026 level until after 2028. So, in addition to the magnitude, the longer duration of the shock (and propagation effect to core inflation) is added here.  

The largest negative impact on growth is in all three scenarios in 2026. Growth in the European economy is lower in both alternative scenarios than in the March 4 base case. Not surprisingly, the bottom in the 'severe' scenario is below that of the 'adverse' scenario.

The expected impact on headline inflation is more differentiated. In both the baseline and adverse scenarios, inflation peaks in 2026 but falls rapidly towards the ECB's 2% target in 2027. In the adverse scenario, it even falls well below 2% in 2028, presumably due to statistical base effects. In the adverse scenario (with a longer-lasting shock), however, inflation only peaks in 2027, with a fall in 2028 to still well above 2%.  

It must be noted here is that underlying core inflation, which the ECB likes to refer to when defining its target, is near 2% again in 2027 only in the baseline scenario, not in the two alternative scenarios.

Implications for ECB policy

For ECB policy, we can draw some preliminary conclusions from this. By choosing its baseline scenario, the ECB indicates that, at the moment, it still mainly interprets the conflict as a temporary shock. Based on this assessment, the ECB could in principle keep its policy rate unchanged for quite some time. The March interest rate decision is already consistent with this, and that conclusion remains valid as long as the ECB sticks to that assessment.

Second, the ECB analysis shows that to some extent, this conclusion also holds for the adverse ECB scenario, with a firmer (but still temporary) energy price shock. In this scenario, however, an unchanged interest rate is less obvious because core inflation there is still above the 2% threshold in 2027. Only in the 'severe' ECB scenario is the policy conclusion for the ECB unequivocally different, namely a rate hike. This is due to the duration of the shock and some propagation into core inflation.

However, we should stress here that the nature and consequences of current political and military developments are extremely uncertain and almost impossible to predict. Perhaps partly to hedge against this extreme uncertainty, money markets are currently pricing in the possibility of an ECB tightening in 2026.  Whatever it will be, the conflict in the Middle East could take a new turn any day. Or in Lagarde's words: the ECB's future policy decisions will be data-dependent.