The European Central Bank is almost certain to stand pat on rates at its meeting tonight. However, the specter of resurgent inflation may compel policymakers to keep the door wide open for a potential hike in September. Against a backdrop of moderating wage growth and economic softness, President Christine Lagarde faces a delicate balancing act.
At 8:15 PM Beijing Time on Thursday, the ECB will announce its interest rate decision. Markets widely anticipate the central bank will keep rates unchanged while preserving ample room for another rate increase in September. This caution stems from renewed upward pressure on Eurozone inflation, driven by Middle East conflicts pushing oil prices back above $90 per barrel and rising energy costs.
Responding to the energy shock, the ECB already raised rates by 25 basis points in June and hinted at further policy tightening. However, subsequent data on prices, wages, economic activity, and inflation expectations have been relatively mild, reducing the immediate necessity for the ECB to act again.
Oxford Economics' Oliver Rakau stated, "We believe the ECB will enter a state of 'hawkish pause'." He views the latest data as only marginally supporting the case for future policy tightening.
"The current data will only barely support further tightening in the future, which aligns with June's projections and largely confirms market pricing," Rakau added.
Financial markets are currently pricing in two to three more ECB rate hikes, with one fully priced in by the end of September and another by the end of April next year. The shift in oil prices is playing a larger role in this market pricing than underlying economic fundamentals. Bank of America forecasts a 25-basis-point hike in September due to the rebound in energy prices.
Nevertheless, most economists believe the 21-nation Eurozone can control inflation without such aggressive tightening. An analyst team from Bank of America noted in a recent report that they see no immediate signs of policy tightening.
They stated, "We are firmly convinced that, regardless of whether the ECB hikes once or twice this year, the policy rate will reach a maximum of only 2% by the end of 2027. Why? We still believe inflation persistence is far lower than expected. The scale of the current energy price shock is fundamentally different from the situation in 2022."
Morgan Stanley's Jens Eisenschmidt also commented, "Even at current oil prices, inflation will largely be at target next year and moderately below target later this year. If you believe that forecast, then there's no rationale for hiking more than twice."
He added, "At a 2.5% level, the deposit rate would be mildly restrictive, so if you are nearing your target, finding justification to cut from that level is straightforward."
Absence of Second-Round Effects from Wages and Services
Thirty minutes after the rate decision, at 8:45 PM Beijing Time on Thursday, President Lagarde will hold a press conference. She will likely need to strike a balance between inflation risks and the soft data: signaling policymakers' continued concern about price pressures and that further tightening remains on the table, while avoiding reinforcing market expectations for hikes that are already largely priced in.
A key reason the ECB can afford temporary patience is the lack of visible "second-round effects" from the energy price surge. Rising energy costs typically push up goods and services prices and prompt workers to demand higher wages.
If wages and prices push each other higher, a wage-price spiral can form. Current wage and labor market data show no signs of this process developing.
Wage growth in the Eurozone continues to slow, and the labor market remains relatively soft, particularly in the largest economy, Germany. Firms surveyed by the ECB also expect wage pressures to ease further.
Consumers have lowered their inflation expectations, and detailed data shows little evidence of second-round effects. Annual inflation in the Eurozone was 2.8% in June, down from 3.2% in May and below the previous forecast of 3%. Citigroup predicts "modest growth" for the Eurozone's July Purchasing Managers' Index (PMI). Due to rising fuel prices, Citigroup expects growth in the consumer confidence index for that month may stall.
Factors like trade tensions and persistently high energy costs will continue to weigh on the Eurozone's industrial sector, which may face difficulties for years to come, putting downward pressure on labor demand.
Heatwaves and Food Prices Present New Inflation Risks
ECB policymakers still believe that even if second-round effects are smaller and delayed, related pressures could eventually materialize. The central bank therefore needs to retain the capacity to act again.
This month's intense summer heat across much of Europe may have damaged crops, posing a risk of rising food prices. Low water levels in key rivers could also trigger shipping bottlenecks.
While food inflation has generally declined in recent months, partly due to weaker prices for commodities like sugar, cocoa, and coffee, the trend could be reversed by abnormal heat and El Niño phenomena.
Barclays noted in a report, "Although food inflation has generally trended lower in recent months, reflecting softer prices for commodities like sugar, cocoa, and coffee, Europe's unusually warm summer combined with El Niño effects could reintroduce upward pressure on food prices."
If the energy shock spreads to other goods, services, and wages, the ECB may be compelled to act again in the autumn. The focus of Thursday's meeting will be to maintain stable rates while clearly signaling that a September rate hike remains a live policy option.
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