The European Central Bank hinted that, influenced by the Middle East conflict, it may raise the benchmark interest rate.

European Central Bank monetary policy committee members have repeatedly hinted that, citing the potential for the Middle East war to trigger price instability, they may raise the benchmark interest rate starting in June. This has again shifted the euro area’s monetary policy toward tightening.

On the 13th, local time, Germany’s central bank, the Deutsche Bundesbank—President Joachim Nagel—said in an interview with the business newspaper Handelsblatt that if the inflation situation does not undergo a fundamental change, the likelihood of rate hikes would increase further. He assessed that the current price trend is nearing the negative scenario set by the European Central Bank (ECB), and noted that the baseline scenario itself already includes two rate hikes. Nagel, who is classified as a relatively hawkish figure toward monetary tightening, also commented that short-term inflation expectations have deviated from the ECB’s target. Inflation expectations refer to the level at which economic actors anticipate future price increases; if this figure rises, pressures for actual price increases and wage growth may also grow.

The ECB’s internal sense of caution is also reflected in remarks by other key figures. Isabelle Schnabel, a member of the Executive Board viewed as influential within the ECB, said in a recent speech that if energy price shocks spread throughout the entire economy, tightening policies would be needed to curb so-called second-round effects. Second-round effects refer to the phenomenon in which increases in energy prices such as crude oil and natural gas gradually spread to transportation costs, food, service fees, and demands for wage increases. This means that, as concerns about energy supply instability are stoked by the Middle East war, the ECB is warning that inflation may not be purely a temporary rise in prices, but could evolve into more persistent inflation.

Market consensus generally holds that the ECB may carry out two to three policy rate increases between the monetary policy meeting on June 11 and the end of this year. The backdrop is a severe economic environment in which the euro area faces both slowing growth and rising prices. In April, euro area consumer prices rose 3.0% year on year, while economic growth in the first quarter increased by only 0.1% quarter on quarter. If prices keep rising while the economy continues to lose momentum, people are increasingly worried about the possibility of stagflation—economic slowdown alongside high prices. With relatively high dependence on energy imports, Europe is more likely, amid ongoing geopolitical conflicts, to face both a worsening cost burden and a contraction in consumption at the same time.

Even so, the ECB’s current atmosphere still leans more toward maintaining price stability rather than immediately stimulating the economy. Nagel emphasized that even when accounting for economic slowdown, the premise for long-term growth is medium-term price stability. ECB President Christine Lagarde, last month, drew a line and said it is premature to label the current situation as 1970s-style stagflation. This contains the judgment that, unlike at the time, today’s degree of inflation persistence and labor market conditions are different. However, if the duration of energy shocks triggered by the Middle East goes beyond expectations, and inflation expectations rise further, the ECB may accelerate its pace of rate hikes even while bearing the risks of economic downturn. This trend is expected to have a considerable impact on future euro area financial markets, corporate financing costs, and the burden of household loans.