The European Central Bank, which unanimously decided to raise interest rates just three weeks ago in response to the conflict in Iran, now finds itself unable to reach a consensus on its next course of action.
As officials gathered in Sintra, Portugal, over recent days for the ECB's annual forum, a significant split has emerged regarding the necessity of further increasing borrowing costs to return inflation to the 2% target. This has led markets to question whether another rate hike will occur this year.
On one side are policymakers, led by Chief Economist Philip Lane, who warn that the inflationary pressures triggered at the onset of the Iran conflict are still unfolding. They caution that the impact could manifest in various ways, including stronger wage demands and delayed increases in food and service costs.
However, the opposing side takes comfort from the sharp decline in oil prices following progress in peace negotiations. They argue that significant second-round inflation effects are unlikely. This view is supported by a substantial drop in the eurozone's June inflation rate, and analysis from Bloomberg Economics also suggests that inflation has already peaked.
A significant policy shift at the ECB's next meeting in July seems unlikely, with investors widely expecting no action. However, by the September meeting, more data—including on wages—will be available. At that point, disagreements over the subsequent steps for monetary policy are likely to intensify.
The contrasting viewpoints are best exemplified by Estonian central bank governor Ulo Kaasik and his Greek counterpart, Yannis Stournaras.
Kaasik stated that it is "reasonable" to think at least one more rate increase is needed. In a separate interview, Stournaras suggested that, given the current circumstances, "perhaps it would be good to stay put for a while."
Such a pronounced divergence of opinion has been absent from recent policy debates. ECB President Christine Lagarde acknowledged the rapid pace of recent developments as the annual forum in Portugal concluded.
Speaking during a closing panel discussion, which also included Federal Reserve Chair Kevin Warsh, Lagarde noted that the balance of risks has shifted. She stated that upside risks to inflation and downside risks to growth "may have become broadly more balanced compared to a few weeks ago, because of what we are observing now, and it is happening very fast."
This rapid change is largely attributed to oil prices falling back to pre-conflict levels, a scenario far below the ECB's assumptions just a month prior. Those earlier projections indicated inflation would remain persistently above the 2% target well into 2027.
In an interview, Finnish central bank governor Olli Rehn downplayed the likelihood of severe inflationary consequences from the Iran conflict, hinting at limited appetite for another rate hike. He stated he does not see "any major second-round inflation effects materializing."
Similarly, Austrian central bank governor Martin Kocher remarked in another interview that the inflation threat "has undoubtedly diminished, at least in the short term."
ECB Governing Council members and national bank governors from Slovenia and Latvia, Primoz Dolenc and Martins Kazaks, both indicated there is no urgency for action in July. Belgian central bank governor Pierre Wunsch went further, suggesting there may be no reason for a second step at all.
Chief Economist Philip Lane, who is responsible for proposing policy options to his colleagues at rate meetings, attempted to keep all avenues open. He stated that policymakers are committed to "not locking ourselves" into a particular interest rate path.
German central bank president Joachim Nagel echoed this sentiment of maintaining flexibility, although he also conceded that the drop in oil prices was "indeed a surprise."
"With the urgency for another hike fading, the improved outlook could widen the divide inside the ECB's Governing Council," said Simona Delle Chiaie, chief eurozone economist at Bloomberg Economics. "While our baseline forecast still includes one final rate increase, we see the downside risks to that call becoming increasingly significant."
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