Will the Iran War Force the ECB and BOE to Tighten as Much as Markets Expect?

No, we do not think so. While the European Central Bank (ECB) and Bank of England (BOE) have adopted a more hawkish tone in response to the Iran-driven energy shock, we believe markets are overpricing the amount of tightening that will ultimately be delivered, with more than 3 hikes priced for the euro area and 2.5 hikes for the United Kingdom. This environment differs materially from the post-Ukraine invasion period, when broad-based and persistent price pressures necessitated steep hikes. In our view, the more important question is not whether oil prices rise in isolation, but whether the supply shock broadens beyond energy into a wider and more sustained increase in input costs. Unless that occurs, which we do not view as the most likely outcome, higher energy costs are more likely to weaken demand and dampen broader pricing pressure than to trigger a lasting inflation spiral. This view supports our recommendation for UK-based investors to overweight UK gilts versus global government bonds.

Though March’s roughly 60% rise in both front-month Brent crude oil and Dutch TTF natural gas futures has been substantial, monetary policy is poorly suited for offsetting an exogenous energy shock. Its main role is to influence domestically driven demand and, thereby, medium-term inflation. Tightening would be warranted if central banks judged that higher energy prices were generating second-round effects through wages, inflation expectations, and core inflation. But higher energy prices are already acting to slow demand by squeezing real incomes, raising business costs, tightening financial conditions, and weakening sentiment. Without clear evidence of those second-round effects, aggressive tightening would mean responding to a supply shock by further weakening already-fragile economies. That, in turn, would increase the risk that central banks are forced to reverse course later as growth and financial conditions deteriorate more than expected.

That logic applies to both the ECB and the BOE, though their starting points differ. In the United Kingdom, despite inflation remaining above target, economic slack has increased in recent months, as reflected in sluggish growth and a softening labour market. In the euro area, inflation had already returned to target and there were tentative signs of an activity recovery before the conflict began. The euro area also appears to retain a somewhat greater scope for a fiscal response than the United Kingdom.

The current situation also differs in meaningful ways from the shock that followed Russia’s invasion of Ukraine. That post-COVID episode was characterised by widespread supply-side disruption, including shipping bottlenecks, labour shortages, and semiconductor scarcity. Demand was also surging as lockdowns ended, supported by unusually strong fiscal stimulus. As a result, inflation was already far higher, standing above 5% in both regions. Labour markets were also materially tighter, with vacancy rates and wage growth both higher and still rising. The contrast between then and now is particularly stark in the United Kingdom. The unemployment rate has been trending higher for most of the past two years, while wage growth has largely normalised. That weaker UK backdrop is one factor behind our preference to moderately overweight UK gilts relative to global government bonds. With growth already soft and potentially deteriorating further and labour market slack continuing to build, the BOE is less likely to validate current market pricing. Gilt yields also remain attractive relative to our estimate of fair value and to yields in broader developed markets peers.

That said, the experience of the Ukraine shock helps explain why both central banks have an incentive to sound hawkish while uncertainty remains high. Emphasising the possibility of further tightening can help restrain inflation expectations and tighten financial conditions at the margin without requiring immediate action. That incentive is particularly strong given lingering memories of having fallen behind the curve in 2022. What matters most is whether there are signs that price pressures are broadening or that medium-term inflation expectations are beginning to drift materially higher. So far, that does not appear to be the dominant signal. For the ECB in particular, history should also reinforce the case for caution in tightening too rapidly in response to an energy price shock. The ECB’s rate hikes in 2008 and 2011 are now widely seen as examples of tightening into commodity-driven inflation shocks just as growth was deteriorating. Today’s policymakers are unlikely to want to repeat those mistakes mechanically. At the same time, they will not want to appear complacent after underestimating inflation persistence earlier in the decade. That tension argues for a middle path: a hawkish posture, and possibly some delivered tightening, but less follow-through than markets are currently pricing.

This view would be wrong if the current shock proves materially more severe or enduring. A persistent, significant impairment of energy flows is not our base case due to both the economic and political incentives faced by the parties involved. Nonetheless, we must recognise that a deeper or longer-lasting disruption to energy supplies could keep oil and gas prices elevated for long enough to generate the second-round effects central banks are most concerned about. In this regard, there is event risk around Tuesday evening’s US-imposed deadline for Iran to reopen the Strait of Hormuz, with further escalation a possibility. If higher energy costs begin to feed clearly into firms’ pricing decisions, wage-setting processes, and, ultimately, core inflation, the policy trade-off would shift. In that scenario, the supply shock would begin to resemble a more entrenched inflation problem, reducing the scope for central banks to look through the initial rise in headline prices.

For now, because we expect this episode to be primarily a growth-damaging supply shock rather than a fresh, demand-led inflation cycle, we believe markets are pricing in more tightening than the ECB and the BOE are likely to deliver.