Central banks edge toward rate hikes as energy shock revives inflation fears

• The ECB is increasingly likely to raise interest rates in June if energy prices remain high and the Iran-related conflict continues.
• Inflation pressure is rising again, while euro-zone growth remains weak, creating a difficult stagflation-like dilemma for policymakers.
• The Bank of England is also moving toward possible rate hikes as higher oil prices threaten to keep inflation elevated.

European Central Bank policymakers are increasingly likely to raise interest rates at their June meeting, unless energy prices ease or the conflict involving Iran shows clear signs of ending. Although no final decision has been made, officials appear to be moving toward a more hawkish stance as renewed pressure in oil and gas markets threatens to push inflation higher across the euro area.

ECB President Christine Lagarde signaled that a rate increase will be seriously considered at the next meeting, after policymakers debated but ultimately rejected a hike this week. The deposit rate remains at 2%, but the central bank will receive updated economic projections in June, giving officials a clearer basis for deciding whether tighter policy is needed.

Lagarde emphasized that the coming weeks will be crucial for assessing the economy and inflation outlook. She noted that the euro area is moving away from the ECB’s previous baseline scenario, though she avoided saying whether conditions are approaching the more adverse scenario outlined earlier this year.

Inflation pressure collides with weak growth

The ECB faces a difficult policy dilemma. Headline inflation has risen to 3%, driven largely by higher energy costs linked to geopolitical tensions. At the same time, the euro-zone economy is showing signs of weakness, with first-quarter growth of only 0.1%. This combination has revived concerns about stagflation, even though Lagarde played down that risk.

So far, ECB officials have not seen strong evidence of second-round effects, such as higher wages or broader price increases feeding through the economy. That has allowed the bank to avoid an immediate rate hike. However, if energy prices remain elevated and the conflict continues, the case for tighter monetary policy may become harder to resist.

A sharper slowdown in economic activity could still persuade policymakers to delay action, but people familiar with the discussions suggest that this outcome is seen as unlikely. Financial markets are already pricing in several rate increases by the end of the year, although some economists believe the ECB may move more cautiously than investors expect.

Bank of England also shifts toward tighter policy

The Bank of England is facing a similar challenge. Its Monetary Policy Committee voted to keep rates unchanged, but several members indicated that they may support an increase soon if inflation risks continue to rise. Chief Economist Huw Pill even backed an immediate quarter-point hike, highlighting growing concern inside the central bank.

The UK central bank has moved away from relying on a single inflation forecast and instead presented several scenarios based on different paths for energy prices. In most of those scenarios, interest rates would need to rise. The most pessimistic case, in which oil prices remain near $130 a barrel, would see inflation peaking at 6.2% in early 2027 and could require a series of rate hikes.

Governor Andrew Bailey remains somewhat more cautious, arguing that weak economic conditions and tighter financial markets are already helping to restrain inflation. Still, he acknowledged that prolonged disruption to energy supplies would create serious risks for the economy.

Geopolitics becomes the key variable

The central issue for both the ECB and the Bank of England is that inflation is being driven less by domestic demand and more by geopolitical and structural shocks. This makes the usual central-bank toolkit harder to apply. Raising interest rates can dampen demand, but it cannot directly increase energy supply or resolve conflict in the Middle East.

For that reason, the duration of the Iran-related crisis has become one of the most important variables for monetary policy. If tensions ease and energy markets stabilize, central banks may have room to wait. If the conflict persists and oil and gas prices remain high, rate hikes in June could become the most likely response.

The coming weeks will therefore be decisive. Central banks in Frankfurt and London are not yet committing to immediate tightening, but their message has clearly changed: inflation risks are rising again, and policymakers are preparing to act if geopolitical conditions fail to improve.