Middle East fighting keeps ECB on alert before rate meeting

Fresh fighting in the Middle East and higher oil prices have put the European Central Bank on alert before its rate-setting meeting on Thursday.

Two weeks of renewed conflict between Iran and the United States have again slowed traffic through the Strait of Hormuz to a trickle, restricting energy exports on a waterway that in peacetime carries about a fifth of the world's oil and natural gas.

The ECB raised rates in June by a quarter of a percentage point to 2.25 percent, becoming the first major central bank to raise rates after the near total closure of the strait. A memorandum of understanding signed last month by Washington and Tehran had raised hopes of a durable solution, but the resumption of fighting has renewed concerns that eurozone inflation, which eased to 2.8 percent in June, could rise again.

UniCredit analysts said energy prices had reversed the decline that followed the US-Iran memorandum of understanding, making the June inflation data less useful for the ECB's current decision. They said the risk of military escalation, low oil inventories compared with pre-war levels and pressure on natural gas prices meant the ECB's Governing Council would probably continue to see risks to price stability as tilted upward.

Rising energy prices can create stagflation, a combination of weak growth and high inflation that is difficult for central banks to manage. Cutting rates to support growth can worsen inflation, while raising rates to control prices can weaken growth further. Some economists criticised the ECB's June rate rise as too forceful and compared it with 2011 rate increases that some blame for weakening the eurozone recovery after the Great Recession.

Most observers expect the ECB to leave rates unchanged on Thursday while it waits to see how long the latest fighting lasts and what effect it has. Berenberg bank senior economist Felix Schmidt said he did not expect any change in interest rates at the meeting. He said oil prices had not risen too sharply and that there were no major signs that higher energy prices were spreading across a wider range of eurozone goods and services.

ING economist Carsten Brzeski also said a hold was the most likely outcome, but said there was still a small chance of a rate rise. He said renewed hostilities had pushed oil prices back to the level the ECB had assumed in its baseline forecast. That forecast sees inflation above the ECB's two-percent target this year and next. Brzeski said limited signs of indirect or second-round effects should have reduced pressure for another increase, but that the ECB's baseline scenario still supported the case for a further hike.

Europe's reliance on imported oil and gas means a sharp energy-price rise could lift inflation and leave eurozone monetary policy exposed to fast-moving geopolitical events. German Governing Council member Joachim Nagel said earlier this month that he did not know what the ECB would have to do in July, and said it might have to raise rates more, stay where it is, or take other action.