Euro zone inflation could surge on lengthy Iran war, ECB's chief economist warns

A prolonged war in the Middle East could cause a substantial spike in euro zone inflation and reduce economic growth, European Central Bank Chief Economist Philip Lane told the Financial Times in an interview published on Tuesday.

A U.S. and Israeli war against Iran widened on Monday, with no end in sight as Israel attacked Lebanon and Iran kept up its attacks on Gulf states, pushing up oil prices by over 10%.

"Directionally, a jump in energy prices puts upward pressure on inflation, especially in the near-term, and such a conflict would be negative for economic activity," Lane said.

"The scale of the impact and the implications for medium-term inflation depend on the breadth and duration of the conflict," he said, adding that the ECB would monitor the situation.

Previous sensitivity analyses done by the ECB showed that such a war would lead to a 'substantial spike' in energy-driven inflation and a 'sharp drop' in output, if there was a persistent drop in energy supplies out of the region, Lane said.

A separate analysis by the ECB from December meanwhile suggests that a permanent oil price spike of this magnitude could lift inflation by 0.5 percentage point and lower growth by 0.1 percentage point.

Euro zone inflation now stands at 1.7%, below the bank's 2% target, suggesting that a small jump in price growth is unlikely to trigger policy action, especially since monetary policy acts with long lags and is considered powerless against near-term swings in prices.

The ECB also tends to look past energy-induced volatility in prices as long as fluctuations do not impact longer-term expectations and do not seep into underlying inflation via second-round effects.

For now, market-based longer-term inflation expectations are little changed and markets continue to expect no change in the ECB's 2% deposit rate all year.

-Reporting by Gursimran Kaur in Bengaluru and Balazs Koranyi in Frankfurt; Editing by Tom Hogue and Raju Gopalakrishnan/Reuters