Escalating tensions in the Strait of Hormuz have triggered a rapid rebound in international oil prices, casting renewed uncertainty over the European Central Bank's policy path, which had recently appeared clearer.
CNBC reported on July 15 that Joachim Nagel, President of the Bundesbank and a member of the ECB's Governing Council, stated that the escalating Middle East conflict and rising oil prices have created "extremely high uncertainty" for the economic outlook. He emphasized that the ECB will remain vigilant and act if necessary. This commentary has reinforced market expectations that the central bank may continue its policy tightening.
While markets still largely anticipate the ECB will hold rates steady at its July 22 meeting, interest rate swaps now indicate a roughly 20% probability of a 25-basis-point hike at that meeting. Investors continue to price in a total of 50 basis points of tightening by next spring, which would raise the deposit rate to 2.75%.
Inflation's Decline Disrupted by Oil Price Rebound
As the military standoff between the U.S. and Iran around the Strait of Hormuz intensifies, international oil prices have surged significantly.
Brent crude has reclaimed ground above $85 per barrel, a stark contrast to its level around $70 just a week prior. For the eurozone, which is highly dependent on energy imports, this suggests the disinflation process could face another setback. Data shows that in 2024, approximately 57% of the eurozone's energy consumption relied on imports, making oil price fluctuations particularly impactful on overall price levels.
In fact, prior to the outbreak of the Middle East conflict, eurozone inflation had largely retreated close to the ECB's 2% target. However, the subsequent rapid rise in energy prices temporarily pushed headline inflation up to 3.2%. The latest data shows that despite an 8.7% year-on-year increase in energy prices, the eurozone's headline inflation for June eased to 2.8%, with core inflation holding steady at 2.4%. This indicates the energy shock has not yet fully transmitted to other sectors of the economy.
Nevertheless, with oil prices spiking again this week, concerns are mounting over whether the disinflation trend can be sustained. The ECB's previous assessment of improving inflation is now facing a new test.
Policy Meeting Coincides with a "Data Vacuum"
The upcoming July 22 meeting presents a unique challenge compared to previous ones.
The preliminary estimate for the eurozone's second-quarter GDP will be released on July 30, followed by the flash estimate for July inflation on July 31. This means the ECB will be making its interest rate decision without access to the latest economic and inflation data.
In a recent report, ING rate strategists Michiel Tukker and Benjamin Schroeder noted that the upcoming eurozone inflation data will be a "key variable to test the market's hawkish pricing." However, they added that even if the data comes in soft, it may not be sufficient to allay market concerns about the risk of secondary inflation effects stemming from energy prices.
The analysts suggest that the policy paths of the ECB and the U.S. Federal Reserve may diverge further. Inflation pressures in the U.S. are more likely to continue easing, whereas the peak for European inflation may not yet have been reached, especially if energy prices keep rising.
ECB's Dilemma: Inflation Versus Recession
The ECB's primary challenge currently lies in striking a balance between curbing inflation and avoiding an economic recession.
In the first half of the year, the ECB implemented four consecutive rate cuts, reducing the deposit rate from 3% to 2%. However, as energy prices began rekindling inflationary pressures, the central bank unexpectedly raised rates by 25 basis points in June, lifting the rate to 2.25% and signaling a clear reversal in policy direction.
Concurrently, the eurozone economy remains weak. First-quarter GDP contracted by 0.2% year-on-year, and many policymakers are concerned that further monetary tightening could further weigh on the economy and potentially push the bloc into a recession.
On Wednesday, Austrian National Bank Governor Martin Kocher stated that the ECB is now focusing intently on the indirect price effects and potential second-round impacts stemming from the Middle East conflict. He noted, "No clear second-round effects have been observed yet, but monetary policy must ensure inflation expectations remain anchored."
Just a few weeks ago, as oil prices retreated, markets had almost completely priced out the possibility of an ECB rate hike in July. Now, geopolitical risks have once again driven up energy prices, leaving next week's policy meeting shrouded in renewed suspense.
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