Economists are cautioning that the European Central Bank's determination to defend its inflation-fighting credibility could lead it to make a costly policy error at its upcoming meeting.
While the ECB has held rates steady since the outbreak of conflict involving Iran, officials now appear convinced that action is needed to prevent soaring energy prices from triggering a broader inflationary surge. However, strong arguments for maintaining a cautious, wait-and-see stance persist, given the eurozone's faltering economic growth and the market's tendency to interpret a single hike as the start of a new tightening cycle.
This dilemma has led some analysts to argue that the ECB should continue monitoring the situation to assess the persistence of the energy price shock, especially with peace negotiations reportedly advancing. They warn that acting too soon risks repeating the widely criticized rate hikes of 15 years ago, which were followed by a worsening debt crisis and forced the central bank into a swift reversal with rate cuts.
"The ECB is single-mindedly focused on proving its policy credibility," said Davide Oneglia of TS Lombard. "The 2011 hikes were a clear policy mistake. The central bank is now overly focused on inflation expectations and haunted by the 2022 high-inflation trauma. Repeating that error is one of the biggest risks now."
Policymakers across the spectrum, from hawkish Executive Board member Isabel Schnabel to more dovish Greek central bank governor Yannis Stournaras, have indicated the central bank can no longer ignore this energy shock and must safeguard market confidence in its commitment to the 2% inflation target.
Latest inflation data for the 21-nation eurozone has climbed to 3.2%, with upward pressures intensifying. Even when volatile energy and food items are excluded, core inflationary pressures have risen significantly. Business pricing plans and long-term household inflation expectations are also moving higher.
Schnabel warned last week that "the risk of inflation expectations becoming de-anchored is rising."
However, not all institutions share this pessimistic view. Some analysts contend that the rise in core inflation is not solely due to pass-through effects from energy costs. Others point out that key indicators like wages are not yet signaling excessive upward pressure.
"If the central bank hikes rates before seeing clear evidence of second-round effects, it risks unnecessary tightening. That's a gamble," noted Michala Marcussen, chief economist at Societe Generale Group.
Historical precedents loom large. In July 2008, the ECB chose to hike rates, only for Lehman Brothers to collapse shortly after, forcing an emergency rate cut reversal within months. More economists, however, draw parallels with 2011, when then-President Jean-Claude Trichet raised borrowing costs twice, only for his successor Mario Draghi to cut rates by year's end.
Policymakers at that time were similarly worried about soaring commodity and energy prices but underestimated the deep-seated fragility of the eurozone's financial system, ultimately contributing to a double-dip recession for the region.
The core of the current market debate is set against a backdrop where the ECB has adopted the most hawkish anti-inflation stance among major G7 central banks, while others like the U.S. Federal Reserve have chosen to wait and assess the ongoing impact of the Iran situation.
Yet the painful experience of 2021-2022 also highlights the pitfalls of a wait-and-see approach. The Russia-Ukraine conflict devastated energy markets, sending eurozone inflation soaring to a historic peak of 10.6%. Despite subsequently launching its most aggressive tightening cycle ever, the ECB was widely seen as having acted too late.
"The central bank ultimately needs to take action to demonstrate its determination to control inflation," said Peter Praet, former chief economist at the ECB.
Finnish central bank governor Olli Rehn has described a potential hike this week as "insurance," while Praet views it more as "a warning shot to show you mean business." He stressed, however, that the ECB must avoid signaling that this is "just the first shot in a series."
Another school of thought supports a rate hike, arguing it would be justified even if subsequent weak economic data forces a policy U-turn. The eurozone's economic momentum continues to weaken, notably in France, where business activity is contracting at its fastest pace so far in 2024.
The eurozone economy contracted at the start of the year, as an unprecedented slump in Ireland forced a revision of data that had initially shown slight growth. According to calculations by Bantleon, excluding Ireland, eurozone growth would have been 0.2% to 0.3%.
In an interview, Katharina Utermöhl, chief European economist at PGIM, stated that policymakers would leave themselves ample room to maneuver, "so that they can signal a readiness to cut rates if the economic fundamentals deteriorate substantially and sentiment surveys continue to weaken."
She expects the central bank's overall communication to be dovish, "which would give them space so that a policy reversal doesn't damage their credibility."
Like investors, economists anticipate two 25-basis-point rate hikes this year, which may align with what President Christine Lagarde has called a "prudent adjustment" to a significant, though likely temporary, inflation overshoot. However, they also forecast at least one rate cut by mid-2027.
Jens Eisenschmidt, chief European economist at Morgan Stanley and a former ECB staffer, expects two hikes in the coming months, both of which would be reversed next year. But he argues this outcome should not be seen as a policy error.
"Acting in June in response to above-target inflation and rising price expectations is likely a carefully weighed decision under uncertainty," Eisenschmidt said. "Similarly, a decision to cut rates a year later could also be based on an assessment that the 'insurance' provided by a tighter policy stance is no longer needed."
This logic does not convince all market participants. Holger Schmieding, chief economist at Berenberg Bank, believes an ECB rate hike would unnecessarily burden households and businesses, arguing that economic weakness itself will gradually erode inflationary pressures.
"There is absolutely no need for the central bank to hike rates while people are under pressure," he stated bluntly. "With domestic demand persistently weak, this temporary price surge is unlikely to morph into a lasting inflation crisis requiring intervention via rate hikes."
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