FRANKFURT, March 19 (Reuters) - The European Central Bank left interest rates unchanged as expected on Thursday but signalled it was closely watching growth and inflation risks from surging oil prices and was ready to act, if that became necessary.
Energy prices have jumped since the U.S.-Israeli war on Iran began on February 28, driving bets that inflation will be pushed far above the ECB's 2% target within months. That could force the central bank to tighten policy to prevent rapid price growth
from becoming entrenched.
Markets now anticipate more than two hikes in the ECB's 2% deposit rate this year on the premise that policymakers accused of acting too late on the 2021/2022 inflation surge will be quicker to pull the trigger this time.
"(The war) will have a material impact on near-term inflation through higher energy prices," the ECB said. "Its medium-term implications will depend both on the intensity and duration of the conflict and on how energy prices affect consumer prices and the economy.
"A prolonged disruption in the supply of oil and gas would result in inflation being above, and growth being below, the baseline projections," the ECB added. "The Governing Council stands ready to adjust all of its instruments within its mandate."
Central banks normally look past such energy shocks since expensive fuel saps consumer demand and reduces profit margins, dragging down economic growth.
But policymakers bet on such a transitory shock four years ago, when Russia's invasion of Ukraine caused oil and gas to spike, only for inflation to surge into double-digit territory and force the ECB to hike rates at its quickest pace on record.
Policy moves will ultimately depend on the duration of the war, and the ECB's own economic projections reflected this uncertainty.
While the bank now sees inflation at 2.6% this year under a "baseline" assumption, the ECB acknowledged risks if high energy prices persisted, and said it would also publish alternative scenarios as part of a separate analysis at 1445 GMT.
Inflation will then come down to 2.0% next year under the baseline and to 2.1% in 2028, the ECB said.
"The Governing Council is closely monitoring the situation, and its data-dependent approach will help it set monetary policy as appropriate," the ECB added.
Financial market pricing now assumes inflation will rise to the vicinity of 3.7% in the year ahead, then take years to come back down to target. These indicators are volatile, however, and are prone to rapid changes as the conflict evolves.
Attention now turns to ECB President Christine Lagarde's 1345 GMT press conference, where investors will scrutinize her comments on what factors may trigger policy action. The ECB will then release its more detailed projections at 1445 GMT.
(Reporting by Balazs Koranyi; Editing by Catherine Evans)
