The link between ECB monetary policy and the conflict in the Middle East is growing stronger. The Governing Council yesterday as expected raised interest rates to 2.50 percent, and while refusing to pre-comment on any particular path going forward, ongoing events in the Middle East look likely to push the ECB towards at least one more hike later in 2026.
This is so, even if European LNG prices are less likely to rise dramatically more than often assumed, but is to an extent also driven by the ECB Governing Council’s focus on the risk of political blowback from rising inflation in the coming European “Super Election Year 2027”. Bottomline, the Middle East looks likely to escalate in the near-term, and the ECB will respond no later than December.
Recent escalation in the Middle East was initially and predictably focused on Iranian strikes against transiting shipping in the Strait of Hormuz, as Tehran cannot accept a new status quo of a more binding U.S. naval blockade of its oil exports, and ongoing material “transponder-less and escorted” GCC oil exports.
The U.S. responded by bombing Iranian installations in the Strait area, after which Iran aimed ballistic missiles against U.S. naval vessels (a significant escalation from just firing these at U.S. bases on land), after which the U.S. Navy began disabling Iranian oil tankers, after which Iran fired a major missile barrage against U.S. bases in Jordan, which was only neutralized by U.S. forces by expending a completely unsustainable amount of Patriot interceptors.
This tit-for-tat was bound to happen eventually, though the speed at which it has unfolded was faster than most would likely have anticipated, reflecting both the clear current unwillingness of the Trump Administration to return to negotiations and a more aggressive Iranian military doctrine – enabled by Iran’s revealed ability to withstand U.S./Israeli airstrikes – increasingly reliant on direct ballistic missile attacks on all U.S. assets in the Middle East, including at sea.
There has in other words been sound reasons for events between Iran and the U.S. to drive the oil price upwards in recent days, and there is no immediate off-ramp visible ahead, despite the U.S. midterms elections fast approaching. The Trump Administration remains unwilling to return to the MoU provisions, and also do not want to return to full-scale war.
So far, the United States retain the capacity to neutralize Iranian missile strikes on regional bases, but the consumption of Patriot interceptors does not look sustainable, providing Iran with an obvious incentive to keep shooting missiles at U.S. bases in the region. Recent reports of Iran having reconstituted its ballistic missile production underlines this risk.
Eventually, the probability of more Iranian missiles getting through rises, and with it the risk of more serious U.S. military casualties. How the Trump Administration will respond to such an outcome represents a further near-term escalation risk, but could also be the starting point of new and more serious negotiations. Once again, it will be up to Donald Trump to decide, so it is difficult to provide rationally based scenario probabilities ahead of time.
The major new risk in the Middle East, however, is the deepening strategic disaster facing Saudi Arabia in its ongoing conflict with the Houthis in Yemen. This week, it appears that the Houthis have made strategic territorial gains along the Red Sea Coast, giving them a real possibility of fully controlling the Arabian Peninsula side of the Red Sea and the Bab Al-Mandeep.
Recalling that the Houthis have already announced a selective blockade of Saudi-linked shipping through the Strait, full Houthi control of the coastline and adjacent Red Sea islands would give them far greater opportunities to enforce such a selective blockade against Saudi Arabia.
In theory of course, the Houthis could also go further and completely block the Bab Al-Mandeep, along the lines of what Iran has previously called for. This, however, in light of the ongoing civil war on the ground in Yemen and the Houthis need for trade and links with the rest of the world looks an unlikely escalation, as Iran does not have full operational control of Houthi military actions.
Instead, recent events are likely to lead to an increasingly effective Houthi counter-blockade of Saudi Arabia, especially if combined with inensified Houthi attacks on key Saudi oil sector infrastructure, including the East-West Pipeline itself.
In short, Riyadh is in mounting strategic trouble, and it largely has only itself to thank for the deterioration. Unless dramatic economic pressure (e.g. a land blockade too) can quickly be brought on the Houthis replicating the U.S. naval blockade of Iran, it looks probable that Saudi Arabia will have to accept to lift its blockade of the Houthis, sending the clear signal to them that escalation against Riyadh works. They and their Iranian backers are not likely to forget this lesson.
The Saudi actions earlier this year in Yemen, during which it actively broke with the UAE and fought UAE’s proxies on the ground in Southern Yemen is bound to have facilitated the poor performance of Yemeni government forces in the Southern coastal provinces now seemingly overrun by the Houthis.
Saudi Arabia can evidently no longer – which should not have been a surprise in light of the development in the war against Iran! – rely on active U.S. military involvement against the Houthis, despite reportedly repeatedly requesting it. The U.S. looks likely to provide military advisors to Saudi Arabia, but any military intervention against the Houthis is likely to have to be carried out by the Saudis themselves. Whether Mohammad bin Salman is willing to risk that remains to be seen, but the apparent unwillingness of the U.S. to come to the aid of its erstwhile strongest ally in the Gulf region is unlikely to be quickly forgotten. De facto, recent events begin the eventual full U.S. military withdrawal from the Middle East.
And lastly for Riyadh, the launch of its on paper potent “Sunni NATO” alliance with Pakistan and Turkey has been a total failure, as Saudi Arabia’s new allies are as reluctant to come to its aid as the old ally in the U.S.. As such, things are likely to get potentially far worse for Saudi Arabia in the coming days and weeks, which in turn could push further upward pressure on oil prices.
Faced with this outlook, the ECB raised rates and issued a new macroeconomic forecast (though the August 19th cutoff date for technical assumptions risks rendering it immediately obsolete, something not even scenario analysis can overcome), assuming Brent oil prices at just below $90/barrel, TTF LNG prices at €51/MW and wholesale electricity prices at €108.7/MWh.
Those are by now optimistic assumptions, as Brent hovers around $100/barrel and TTF around €80/MW with no obvious reason per the above to think this will change in the near-term.
A lot of concern is centered around natural gas prices in the EU and the risk that they – like in 2022-23 – will feed into also dramatically increased electricity prices. This risk, however, should not be overestimated, as there are sound reasons for why European gas prices are not likely to rise much more than they already have.
Yes, especially the Netherlands and Germany are now subject to the “weather risk” of an early cold winter, due to current low gas storage levels and ongoing loss of Qatari supplies. Yet, unlike in 2022-23, both have ample LNG access points and hence the opportunity to attract more LNG supply during the winter.
All they have to do is to outbid others for shipments, which at current prices is already happening as LNG buyers like Pakistan and other developing economies are priced out of the market. This shifts demand destruction from higher gas prices away from Europe and towards these lower income countries (prompting them to return to coal and solar in the future). Risks of dramatic gas price squeezes in North Western Europe – even in a cold winter – are hence not that high.
And it should also be recalled that overall gas consumption in Europe has dropped about 20 percent since 2022-23, meaning that roughly similarly sized storage facilities can be “more empty” and still provide the same share of expected seasonal demand. The ECB is hence in no credible scenarios likely to face a situation similar to that of 2022-23, and hence will not have to contemplate replicating a similarly aggressive monetary policy stance. Much less will suffice.
Recent elections everywhere underlines the political risk for incumbents from rising inflation and loss of voters’ purchasing power. President Lagarde as former finance minister in a country with crucial elections in 2027 will be well aware of this risk, as will all her colleagues on the Governing Council.
Europe’s electoral calendar is hence a real reason for the ECB to err on the hawkish side right now, as mainstream parties across Europe cannot politically afford additional inflation risk.
Combined with a macroeconomic forecast that also upgraded both growth and inflation for 2027 – incidentally suggesting that the euro area neutral interest rate have increased above 2.50 percent and hence does not represent a hindrance for further rate hikes – this now makes it the base case that the ECB will raise rates one more time in 2026. Further rate hikes are not impossible, but are not likely to be driven by European natural gas price increases.
In sum, things look likely to escalate further in the Middle East, Saudi Arabia (and hence its oil customers) is in real strategic trouble, and the ECB looks likely to hike rates further without being bothered by concerns of monetary policy turning restrictive by rates going above a slowly rising euro area neutral rate.
Jacob
