UBS says Middle East conflict complicates the European Central Bank's policy outlook

Investing.com - UBS stated on Monday that the European Central Bank will keep interest rates unchanged at 2% next week. However, after Iran war-driven oil prices surged 27% and European natural gas prices increased 73%, the bank faces pressure to raise rates sooner than expected. This also puts upward pressure on inflation and weighs on economic growth.

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The market has already reflected this shift. The pricing, which initially pointed to a 6-8 basis point cut by 2026, has shifted to a total of a 32 basis point hike by December 2026, UBS said. In February, Eurozone inflation reached 1.9% year-over-year, 0.2 percentage points higher than expected, further amplifying this shift.

UBS stated that, given that the technical assumptions established around February 20 by the European Central Bank are outdated before the escalation of the situation, the bank may present multiple forecast scenarios at the March 19 meeting.

Under the baseline scenario before the conflict, the bank expects the ECB to maintain its GDP growth forecast at 1.2% for 2026, and 1.4% for 2027 and 2028. It also raised the overall inflation forecast by 0.1 percentage points, to 2% in 2026 and 1.9% in 2027.

A short-term energy shock scenario would push inflation 10-20 basis points above the baseline and reduce 2026 GDP growth by 10 basis points. An extended duration of the conflict would cause a larger and more persistent impact on both.

The ECB has long ignored external energy shocks, viewing initial price impacts as unavoidable and possibly temporary. However, UBS said policymakers will closely monitor second-round effects, where energy-driven inflation feeds into wage growth, making price pressures more persistent.

ECB Vice President Luis de Guindos warned last week that prolonged conflict could raise inflation expectations. UBS noted that policymakers including German Bundesbank President Joachim Nagel, Finnish Central Bank Governor Olli Rehn, and Chief Economist Philip Lane see the duration of the conflict as a key variable.

The data presents a complex picture. Core inflation in February rose from 2.2% in January to 2.4%. Service sector inflation remained at 3.4%.

UBS’s wage tracker shows that wage growth slowed from 3.4% in December to 3.1% in January. The Eurozone composite PMI was 51.9 in February, and the unemployment rate fell to 6.1% in January.

UBS stated that the ECB will refuse to pre-commit to any interest rate path and can no longer describe itself as being in a “favorable position,” instead shifting to a wait-and-see mode as the conflict and its economic consequences become clearer.

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