Policy makers at the European Central Bank (ECB) and the Bank of England (BoE) are widely expected to hold interest rates steady in the near term while adopting a hawkish tone as they assess a fresh surge in energy-driven inflation. Analysts note the emphasis has shifted from reacting solely to the initial spike in fuel costs to watching for so-called second-round effects, particularly on inflation expectations.
Monetary recalibration: watching second-round effects
According to a recent analysis from UBS Group AG, authorities are prioritizing the trajectory of inflation expectations that can emerge after an initial energy price shock. This emphasis means central banks may be less inclined to immediately tighten policy in response to the first-round price moves, instead reserving policy action to counter persistent or self-reinforcing inflation dynamics.
Market pricing currently factors in multiple rate increases in 2026. Yet, UBS and other analysts argue that for the Eurozone and the U.K., a cautious watch-and-wait approach is the more probable path, with policymakers signalling preparedness to act rather than enacting pre-emptive tightening while growth shows signs of slowing.
Fiscal buffers versus monetary vigilance
Central banks face a delicate trade-off: contain sticky inflation without inflicting a sharp downturn in medium-term growth. UBS highlights that higher inflation typically accompanies weaker growth. Still, the risk of a repeat of the 2022 contraction could be mitigated by substantial fiscal expansion. The scale of this fiscal support - described as "fiscal firepower" not seen since the pandemic - is expected to bolster demand and soften the impact of the energy shock on large economies such as Germany.
As a result, the ECB and BoE are likely to continue a posture of conditional readiness, indicating they can tighten policy if needed while avoiding premature rate hikes that would further depress an already cooling economy.
Structural resilience in energy and production
The resilience of Europe’s economy is also being underpinned by structural shifts in energy consumption since the 2022 crisis. Industry has reduced reliance on imported gas through accelerated investments in solar, wind, and heat pump technologies. In addition, the energy intensity of output has fallen as services form a larger share of the economy and electric vehicles now account for 20% of new car registrations. These developments mean the region remains vulnerable to global price spikes but is materially better positioned to absorb the current shock than it was in prior cycles.
Markets, however, are concentrating on weaker pockets within manufacturing where output has declined even while overall gross value added remains relatively steady. That divergence highlights how sectoral mix and productivity differences matter for both inflation trajectories and equity performance.
Geopolitical timeline and market implications
Investors are paying close attention to an April 6 deadline related to the Iran conflict, which could determine how long the prevailing energy premium persists. UBS indicates that provided second-round inflation effects stay contained, the strategy of a hawkish hold will likely persist, creating a stabilizing yet restrictive backdrop for European equities through the first half of the year.
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