The European Central Bank is expected to keep its policy rate at 2% at its next meeting, but UBS says the recent escalation of the Iran conflict has materially altered the bank's policy calculus. A surge in oil prices of 27% and a 73% rise in European gas prices have created upward pressure on inflation while simultaneously weighing on growth prospects, according to a UBS note dated Monday.
Market pricing has moved quickly to reflect the new risk environment. Where expectations previously pointed to cumulative rate cuts of 6-8 basis points through 2026, markets now show 32 basis points of cumulative hikes by December 2026. UBS said the shift in market-implied rates was amplified by February's eurozone inflation reading of 1.9% year-on-year - 0.2 percentage points above consensus.
With its technical assumptions fixed around Feb. 20, before the escalation in the Middle East, UBS said the ECB will likely present multiple forecast scenarios at its March 19 policy meeting. The bank noted that those pre-war assumptions are now outdated and that alternative paths need to be set out to account for the evolving energy shock.
Under what UBS describes as the pre-war baseline, the ECB would keep its GDP growth forecasts at 1.2% for 2026 and 1.4% for both 2027 and 2028. Headline inflation forecasts in that scenario would be nudged up by 0.1 percentage points to 2.0% for 2026 and to 1.9% for 2027.
UBS outlined two shock scenarios tied to the energy spike. A short-lived energy shock would lift inflation by 10-20 basis points and shave 10 basis points off 2026 GDP growth relative to the baseline. A prolonged conflict, UBS warned, would produce a larger and more persistent hit to both inflation and growth.
The ECB has historically attempted to look through external energy shocks, treating initial price moves as unavoidable and potentially temporary. UBS said that, even so, policymakers will be vigilant for any second-round effects - in particular, energy-driven price rises feeding into wages and thus making inflation more persistent.
Senior ECB officials have flagged the duration of the conflict as the critical variable. ECB Vice President Luis de Guindos warned that a prolonged conflict could push inflation expectations higher. Other policymakers named by UBS - Bundesbank President Joachim Nagel, Bank of Finland Governor Olli Rehn and ECB Chief Economist Philip Lane - have similarly emphasized that the length of the conflict will determine its economic consequences.
Recent underlying economic data offer a mixed portrait of eurozone momentum. Core inflation increased to 2.4% year-on-year in February from 2.2% in January, while services inflation held steady at 3.4%. UBS's negotiated wage tracker slowed to 3.1% in January from 3.4% in December. Activity indicators point to modest expansion, with the eurozone composite PMI at 51.9 in February, and the labour market showing some resilience as the unemployment rate fell to 6.1% in January.
Given the new uncertainties, UBS expects the ECB to avoid pre-committing to any particular rate path. The bank said the central bank could no longer describe itself as being "in a good place" and is more likely to adopt a wait-and-see stance until the conflict's duration and its economic effects become clearer.
Key implications
- Policymakers will present scenario-driven forecasts at the March 19 meeting to reflect updated energy assumptions.
- Market expectations have shifted toward tighter policy over 2026 as a result of higher energy prices and stronger-than-expected inflation data in February.
- Monitoring second-round inflation effects and the conflict's duration will be central to ECB deliberations.