ECB waits for signals from the economy. War with Iran raises risks to inflation and growth in the euro area

• The ECB says it is still too early to fully assess the economic impact of the Iran conflict on the euro area, so policymakers should closely watch incoming data and avoid rushing into decisions.
• The war creates a classic supply shock: it raises energy and commodity prices, increases inflation risks, and at the same time threatens already weak euro area growth, especially through potential disruptions such as a Strait of Hormuz blockade.
• The ECB’s main concern is whether higher energy costs will trigger longer-lasting “second-round effects” across the economy; if inflation expectations rise and price pressures become persistent, the central bank may have to respond.

The European Central Bank is still unable to clearly assess how strong the full impact of the war with Iran will be on the euro area economy. As Álvaro Santos Pereira, a member of the ECB’s Governing Council, emphasizes, the conflict is too recent to draw firm conclusions, so for now the central bank should closely monitor incoming data and refrain from hasty reactions.

Too early for a full assessment of the conflict’s effects

According to Pereira, the current situation requires caution because this is a classic supply shock. Such shocks usually lead at the same time to weaker economic growth and higher inflation, putting the central bank in a particularly difficult position. On the one hand, energy and commodity prices are rising; on the other, economic activity is weakening. For the euro area, this means worsening conditions, although at this stage the negative impact of the conflict is not yet seen as dramatic.

A supply shock puts the ECB in a difficult position

Pereira notes that the euro area economy is currently somewhere between the ECB’s baseline scenario and the adverse scenario it had considered. Even before the current crisis, economic growth in the euro area had been running at around 1%, which in itself pointed to limited recovery momentum. In this situation, any additional external shock, especially one related to the energy market and geopolitical tensions in the Middle East, increases the risk of a further weakening in economic conditions.

The ECB is paying particularly close attention to developments surrounding the fighting in the Middle East and the potential consequences for Europe of a blockade of the Strait of Hormuz. This channel could be of key importance for oil prices, transport costs, and more broadly for cost pressures in the economy. For the central bank, however, the most important issue will not be the temporary rise in prices itself, but the possibility of so-called second-round effects. This refers to a situation in which higher energy and commodity prices begin to spread into other sectors of the economy, pushing inflation higher in a more lasting way.

The biggest risk is entrenched inflationary pressure

In Pereira’s view, only clear signs that higher inflation is becoming entrenched, along with rising inflation expectations, should prompt the ECB to react. If such signals appear in the data, the central bank will have to respond. If, however, price pressure proves limited and temporary, it will be more appropriate to continue observing the situation and make decisions with great caution. This is particularly important at a time when less than two weeks remained before the ECB’s next interest-rate decision.

Europe needs not only caution, but also reforms

In the Governing Council member’s opinion, short-term caution in monetary policy should not obscure the broader picture. Pereira points out that for more lasting growth, Europe also needs structural measures, above all faster completion of the single market. Deeper economic integration could increase Europe’s resilience to external shocks and improve its long-term growth prospects.

For now, the ECB therefore remains in a mode of vigilant observation. The conflict with Iran is already worsening economic conditions in the euro area, but the scale of its impact has not yet been determined. The coming weeks and incoming data will show whether this is a temporary disruption or the start of stronger and more persistent inflationary pressure that would force the central bank to respond.