Facing Geopolitical Uncertainty and Risks of Inflation

By Claudia Fontanive-Wyss, Portfolio Manager at Vontobel

The European Central Bank (ECB) has recently acknowledged that the ongoing conflict poses a major risk, but it has not changed its monetary strategy. Instead, the ECB has adopted a more reactive posture based on data, suspending the normalization trajectory of its policy rather than reversing it. In the face of weaker economic outlooks, it is unlikely that new rate hikes will occur.

The ECB is expected to maintain its current stance, using a cautious rhetoric to preserve its flexibility and avoid premature action. President Lagarde has emphasized “graduality” and “optionality” in ECB communications, aiming to prevent the bank from falling behind while protecting economic growth.

Inflation remains the ECB’s central priority for upcoming meetings. Price stability is its main mandate, and with well-anchored inflation expectations – as reflected in market measures like the 5Y5Y – it is likely that the ECB will refrain from raising rates.

Policymakers are monitoring overall and underlying inflation, wage growth, production price impacts, as well as survey and market-based expectations. These elements are crucial as energy and food prices are particularly vulnerable to the conflict.

While inflation is a priority, the ECB also watches growth, employment, and other broader social objectives closely tied to its price stability goals. Latest staff projections indicate modest growth, reinforcing the need for cautious action.

The duration of the conflict will significantly influence Europe’s economic outlook. In the event of a quick resolution, energy prices could drop to around $80 per barrel, supply chain disruptions would ease, and growth could accelerate, albeit from a lower base than originally projected for 2026.

Inflation pressures are expected to moderate, and European credit spreads, widened by uncertainty, are likely to narrow. Corporate bonds have largely recovered to pre-war levels, although spreads remain wider than January lows. If the conflict persists, high energy prices would force Europe to adapt by increasing LNG imports and curtailing demand.

Growth would stagnate, but recession could be avoided, and credit fundamentals would remain strong. The ECB would uphold stable policies and continue monitoring the situation. A severe escalation – currently not anticipated by markets – would push inflation above medium-term targets, potentially forcing the ECB to tighten policy amidst economic weakness, impacting energy-intensive sectors and the most vulnerable economies.

For 2026, it is unlikely that the ECB will raise rates under current conditions. The central scenario foresees one or two rate cuts in the second half of 2026, provided clear evidence shows inflation converging towards the 2% target and growth prospects stabilize. Any cuts would likely happen only after data confirmation, making early 2026 too premature for such moves.

The ECB could resort to its Transmission Protection Instrument (TPI) if sovereign debt spreads widen, with France and Italy posing the highest risks due to their budget deficits and economic vulnerabilities. France faces political uncertainty and low business confidence, while Italy’s energy dependence and weak exports make it vulnerable to external shocks.

If inflation rises, the ECB’s tools remain monetary, including QE, QT, TPI, and TLTRO, but it lacks direct fiscal powers. However, national governments have shown more fiscal willingness, evidenced by the consensus on rearmament at the February 2025 Brussels summit and renewed energy sovereignty initiatives. This increased fiscal activism supports a coordinated recovery and lightens the burden on monetary policy. The ECB has urged governments to follow Draghi’s competitiveness report for structural and fiscal reforms, and the momentum for these reforms is stronger than two years ago.

In conclusion, the ECB’s cautious, data-driven approach, supported by careful communication and enhanced fiscal coordination, is suited to the current environment. Flexibility and the ability to respond to changing risks will be crucial as policymakers work to maintain stability and support the European recovery throughout 2026.