Economists are warning that the European Central Bank's determination to defend its inflation-fighting credibility could lead it to commit a costly error at its meeting this week.
While the ECB has held steady since the outbreak of the Iran conflict, officials now appear convinced of the need to raise interest rates to prevent soaring energy prices from triggering a broader wave of inflation.
However, strong arguments for maintaining a wait-and-see, cautious approach remain: the eurozone economy is faltering, and market participants are highly likely to interpret a single rate hike as the start of a new cycle of consecutive increases.
This dilemma has led some analysts to argue that the ECB should continue to observe and assess the persistence of the current energy price shock, especially with the US and Iran advancing peace agreement talks.
They caution that acting too soon risks repeating the widely criticized rate hike of 15 years ago, which was followed by a worsening of the European debt crisis and ultimately forced the central bank to cut rates to correct its mistake.
"The ECB is single-mindedly focused on proving its policy credibility," said Davide Oneglia of TS Lombard. "The 2011 hike was a complete policy error. The central bank is now overly focused on inflation expectations and trapped in the psychological shadow of 2022's high inflation. Repeating that mistake is one of the biggest current risks."
Policymakers ranging from hawkish Executive Board member Isabel Schnabel to more dovish Greek central bank governor Yannis Stournaras have stated that the bank can no longer ignore this round of energy shocks and must uphold market confidence in its commitment to the 2% inflation target.
Latest data shows inflation in the 21-country eurozone has risen to 3.2%, with upward pressure intensifying. Even excluding volatile energy and food items, core inflationary pressures have increased substantially; corporate pricing plans and long-term household inflation expectations are also rising.
Schnabel warned last week that "the risk of inflation expectations becoming unanchored is rising."
Not all institutions share this pessimistic view. Some analysts believe the rise in core inflation is not entirely due to the pass-through of energy costs; others argue that key price indicators like wages are not yet signaling excessive upward momentum.
"If the central bank rushes to hike rates before clear evidence of second-round inflation transmission effects emerges, it risks unnecessary tightening. It's taking a gamble," noted Michala Marcussen, chief economist at Societe Generale Group.
Historical precedents loom large: In July 2008, the ECB opted to raise 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-end.
Policymakers at that time were also worried about surging commodity and energy prices but underestimated the deep-seated fragility of the eurozone financial system, ultimately plunging the region into a double-dip recession.
The core context of the current market debate is that among the G7 central banks, the ECB has expressed the most hawkish anti-inflation stance, while others like the Federal Reserve have chosen to wait and assess the subsequent impacts of the Iran situation.
Yet the painful experience of 2021-2022 highlights the drawbacks of a wait-and-see policy: the Russia-Ukraine conflict devastated energy markets, sending eurozone inflation to a historic peak of 10.6%. Even after launching its largest-ever tightening cycle, the central bank is widely seen as having acted too late.
"The central bank ultimately needs to take concrete action to demonstrate its resolve to control inflation," said Peter Praet, former ECB chief economist.
Finnish central bank governor Olli Rehn has termed a potential hike this week an "insurance hike," while Praet views it more as "a warning shot to show you mean business." He emphasized, however, that the bank must avoid signaling that "this is just the first shot in a series of hikes."
Another school of thought supports a rate hike, arguing it would be justified even if subsequent weak economic data forces a policy reversal. The eurozone's economic expansion momentum is persistently weakening, with France being a notable example, where business activity contraction has hit its highest level since 2024.
The eurozone economy contracted at the start of the year, as an unprecedented contraction in Ireland forced authorities to revise data that initially showed weak growth. According to Bantleon's calculations, excluding Ireland, eurozone growth would be 0.2% to 0.3%.
In an interview, Katharina Neiss, chief European economist at PGIM, stated that policymakers would leave themselves ample room for maneuver, "so that they can signal the ability to cut rates if the economic fundamentals deteriorate substantially and various sentiment surveys continue to weaken."
She anticipates the central bank's overall messaging will be dovish, "This will give them space so that a policy reversal does not affect their credibility."
Like investors, economists expect two 25-basis-point rate hikes this year, which may be what President Christine Lagarde referred to as a "prudent adjustment" to a large but likely temporary inflation overshoot. However, they also anticipate 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 stated this outcome should not be viewed as a policy error.
Eisenschmidt said that acting in June to address above-target inflation and rising price expectations "is likely a carefully weighed decision under uncertainty."
"Similarly, the 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 fails to convince all market participants. Holger Schmieding, chief economist at Berenberg Bank, believes an ECB rate hike would only unnecessarily burden households and businesses, as economic weakness itself will gradually erode inflationary pressures.
He stated bluntly: "There is absolutely no need for the central bank to hike rates while people are under financial pressure. With domestic demand persistently cooling, this temporary price surge is unlikely to evolve into a long-term inflation crisis requiring intervention via rate hikes."
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