The European Central Bank is expected to raise its key interest rate Thursday for the second time since the start of the war between the U.S. and Iran, but signal caution about further moves that would take borrowing costs to levels that restrain economic activity.
The eurozone's annual rate of inflation rose in August to 3.3%, the highest level in almost three years and well above the ECB's 2% target. However, there were no signs of the second-round effects that policymakers always fear when energy prices shoot higher, as they have since the war closed the Strait of Hormuz.
The ECB's own figures indicate that workers haven't secured higher pay rises to cover their higher energy bills, which would in turn pressure their employers to raise their prices so as to preserve profit margins.
But the longer the war continues, and the longer energy prices remain high, the more likely it is that workers will act. In particular, policymakers are aware that as colder weather returns toward the end of the year, home heating bills are set to soar.
To limit the risk that second-round effects will build as the war drags on, policymakers are expected to raise the key interest rate to 2.5% from 2.25%, taking it to the upper limit of the neutral range, within which it is neither restraining nor stimulating the economy.
Moving further would require a decision to actively restrain growth. The eurozone has proved surprisingly resilient in the face of higher energy prices, and was the only major economic area to record a pickup in the second quarter.
That resilience will reassure the ECB that it can raise its key interest rate without causing too much pain to businesses and households. But the very development that would trigger a third rate rise--persistently high energy prices--would also weaken consumer spending, a key source of resilience.
Economists at Morgan Stanley are among those who see Thursday's expected rate rise as the last for some time.
"Tightening after September would need strong indications of a more robust business cycle and more persistent inflation," they wrote in a note to clients.
The recent rise in bond yields adds a new element of uncertainty. The ECB isn't the only driver of higher borrowing costs in the eurozone.
Over recent weeks, yields on European government bonds have jumped, partly reflecting the realization that the war and the high energy prices it brings are set to be more long-lasting than anticipated.
Higher yields on government bonds mean higher interest rates for businesses and households. The ECB will likely be wary lest its own moves combined with developments in government bond markets push borrowing costs too high, and tip the economy into recession.
"The main challenge for the central bank will be not to add too much fuel to the fire," wrote Carsten Brzeski, an economist at ING Bank, in a note to clients.
With that goal in mind, ECB President Christine Lagarde is likely to underline the oft-repeated message that rates aren't on a predetermined path, and in particular that investors shouldn't assume that further rises are inevitable, even if there seems to be no end to the war in sight.
Equally, Lagarde is unlikely to rule out a further move, and some economists see an increased likelihood of a third increase in the key rate in December.
"We expect energy price pressures to remain elevated in the coming months and more evidence of broadening price pressures to suggest to the ECB that another hike is likely to be required to bring inflation sustainably back to 2%," economists at BNP Paribas wrote in a note to clients.
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