European Central Bank President Christine Lagarde and Bank of England Governor Andrew Bailey will spend the summer trying to shake off the ghosts of their past inflation mistakes as they move to combat spiraling prices.
Europe’s most powerful economic officials face a haunting dilemma: how to respond to the Iran war without repeating the errors that followed the Covid pandemic and Russia’s invasion of Ukraine.
Their decisions will shape the continent’s economic future for years to come — and their own personal legacies.
As U.S. President Donald Trump’s war in Iran threatens to once again send prices spiraling upward, the two central banks have to decide in real-time what lessons to learn from 2022 when a tepid response allowed inflation to spike to double-digit figures.
But the lesson isn’t as simple as just hiking rates as quickly as possible.
“The question for any central bank right now is trying to weigh up two possible policy mistakes. One is that you act later than you should, and then maybe you end up having to do more than you would like to,” said Paul Hollingsworth, head of developed market economics at French bank BNP Paribas.
“The other is that you hike when you shouldn’t, because actually the underlying dynamics are quite different.”
Move too slowly, and policymakers risk allowing higher energy costs to seep into inflation expectations, wage demands and broader prices, undermining the credibility they fought to rebuild after 2022. Move too aggressively, and they risk choking off already fragile growth in response to what could prove another temporary supply shock.
Economists expect the ECB to raise interest rates by 25 basis points on Thursday, while the BoE is expected to stay put one week later.
But for both institutions, June is less about the size of the move than the judgment behind it. For Bailey, who has a little under two years left of his mandate, and Lagarde, who is expected to leave before her eight-year term is up in October 2027, it may be remembered as prudent vigilance — or another lesson learned the hard way.
The decisions look modest. The stakes are not.
Déjà vu
After all, they have been here before.
Both the ECB and the BoE are still reckoning with the inflation shock that followed Russia’s invasion of Ukraine, when they were accused of reacting too slowly as inflation surged into double digits. The ECB is also haunted by its 2011 mistake — raising rates into an energy shock before being forced into a humiliating U-turn as the economy faltered.
With inflation in the eurozone at 3.2 percent — more than a percentage point above the ECB’s target and its highest level since 2023 — and the Middle East conflict clouding the outlook, the ECB is expected to opt for cautious tightening. Markets anticipate Thursday’s hike to be followed by two more moves, lifting the deposit rate to 2.75 percent by year-end.
Thursday’s decision will likely be accompanied by higher inflation forecasts, lower growth projections and a warning that policymakers remain alert to the risk of inflation becoming more deeply embedded in the economy.
“If I look at the ECB, it does seem to be more concerned about a repeat of the 2022 period than it does, for example, a repeat of 2011,” said Hollingsworth.
As the ECB attempts to navigate between two competing historical lessons, Lagarde is expected to keep all options open. “There will be no guidance, no pre-commitment,” Deutsche Bank economist Mark Wall said in a note to clients.
Yet while the risk of another inflation shock is real, there is far less certainty that the latest oil-price surge will prove persistent — raising the prospect that tighter policy could turn out to be an unnecessary and costly faux-pas.
“An interest rate hike would be a big mistake,” Berenberg economist Holger Schmieding said. He warned that any follow-up hikes would sow the seeds of an economic downturn.
“This is not 2022,” Schmieding said. “There is little reason for a central bank to weaken demand further when the economy is already being hit by higher energy costs and heightened uncertainty.”
For Britain, where inflation is running at 2.8 percent, a lot has changed since Covid. Back in 2022, the job market was hot, central banks had kept rates low and the government was pumping money into the economy. Now, there is very little by way of economic stimulus.
The BoE’s apparent divergence from the ECB may be less dramatic than it looks. Before the latest jump in energy prices, many monetary policy committee members had been edging toward cuts from the current 3.75 percent benchmark rate. Holding rates steady therefore amounts to a tightening relative to where policy had been heading.
Bailey has argued the central bank has a “bit of time” because conditions have effectively tightened, with mortgage rates jumping up, as the Bank’s previous plans to cut interest rates this year were dropped.
The Bank is also weighing signs of a weakening economy such as a rise in unemployment and a slowdown in the job market.
As Schmieding sees it, the BoE’s hold is more justified than an ECB hike given still stubborn domestic price pressures following last year’s rise in labour costs.
But the risk, and the haunting lesson from the past, is that wait for all the data to come through, all the boxes to be ticked, and it’s too late to stop prices from taking off.
“Now the shock has gone on for long enough,” BNP’s Hollingsworth said of the conflict in the Middle East. “It’s become less of a question of whether central banks do or do not need to respond. It’s about the magnitude and timing.”