West Asia Crisis | At the mercy of oil: Five questions for the European Central Bank

Jolted from the 'good plac' policymakers reckoned they were in just weeks ago, the ECB outlook is now "in the hands of military generals."

London: The European Central Bank meets next Thursday, with traders betting that surging oil prices could push it to hike interest rates as early as this year.

War in the Middle East has rekindled fears of an energy-driven inflation shock at a time when memories of the 2022 crisis following Russia's invasion ⁠of Ukraine remain fresh.

Jolted from the 'good place' policymakers reckoned they were in just weeks ago, the ECB outlook is now "in the hands of military generals", as ⁠one source put it to Reuters.

Here are five key questions for markets:

What will the ECB do ‌on Thursday?

Hold rates at 2%. It's anybody's guess how ​long the conflict will last and where energy prices end up, so the ECB will acknowledge the uncertainty and President Christine Lagarde has already promised to do everything needed to keep inflation in check.

"They can no longer say they're in a good place because they don't know whether they're in a good place," said UBS chief European economist Reinhard Cluse. "It will all depend on what comes next."

Does the war mean a new inflation shock?

Inflation is expected to rise, but ​whether that turns into a shock will depend on ⁠the duration of the conflict and when tankers can travel through the key Strait of Hormuz again.

Oil prices have seesawed, nearing $120 earlier this week .

At around $100 they are still up 35% since the war started and 60% higher this year. European gas prices are up nearly 60% this month alone.

This would raise inflation significantly. A past ECB analysis showed a permanent 14% oil and gas price jump would raise inflation ⁠by 0.5% and hit ‌growth by 0.1%, having a similar impact for a second year before fading.

A derivative investors use to hedge euro zone inflation risk over the next two years has jumped to around 2.5% from 1.75% before the war.

Before the conflict, ‌the ECB expected inflation to undershoot its 2% target this year and next, providing some buffer.

Compared to 2022, risks are tilted more to a growth hit than an inflation jump, TS Lombard ⁠economist Davide Oneglia said, given the economy is far from a post-pandemic boom where inflation was already rising. The jobs market is also weaker.

How would the ECB react to an energy inflation shock?

For now, ‌what's clear is the prospect of another rate cut this year looks off the table and traders are betting ‌on at least one hike this year.

Burnt by the experience of 2022, when it missed the onset of what turned out ‌to be a historic inflation shock, the ECB is likely to steer clear of describing inflation as "transitory".

Policymakers look set to keep a ‌cool head but have promised swift action but only if they think inflation is at risk of getting entrenched in higher inflation expectations, wage demands or prices of goods.

Some economists say it would take oil prices above $100 for several months and evidence of those second-round effects to warrant rate hikes.

What will the ECB's new projections show?

The ⁠projections will only factor in ⁠the first few days of the war, so are unlikely to capture the full extent of the spike in energy prices. The real focus will be on any scenario analysis the ECB presents.

Vice President Luis de Guindos said such analysis was likely as was the case when Russia invaded Ukraine.

Oil prices had already started rising pre-conflict and euro zone inflation unexpectedly jumped last month, putting upward pressure on projections the ECB presented in December.

Will Lagarde see out her term at the ECB?

ECB chief Lagarde has tried to dampen speculation that she might leave her post early while offering no outright denial. This would allow French President Emmanuel Macron's involvement in appointing her successor.

The door remains ajar to an early departure. ​Investors see former Dutch central banker Klaas Knot and Spain's De Cos as two likely candidates. Knot is seen as hawkish but pragmatic and ​De Cos a bit more dovish. Neither is seen changing ​the way the ECB operates.

Analysts note a successor is up in the air given Lagarde herself wasn't a candidate initially in 2019 and a new leader could leave more of their mark if ​inflation rises.

However, a new inflation threat raises the chance that Lagarde might see out her full term until October 2027, Deutsche Bank said.