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The ECB hiked its three key interest rates for the first time since 2023 as it attempts to get out ahead of any potential second-round effects from the war in Iran, which has already pushed inflation back above target. Further ahead, we think the ECB will hike rates at least once more this year to ensure interest rates are at least mildly restrictive, but the economy is much weaker than it 2022 so it will need to be careful to not hike too aggressively. Ultimately, we think the scope for more than two, or at best three, rate hikes is limited given the sharp downturn in the survey data which suggest growth will slow sharply in Q2.
Uncertainty too high to change policy
As expected, the ECB hiked rates by 25bps today in a unanimous vote. Inflation has jumped to 3.2% and President Lagarde has emphasised that we have seen a “broadening out” of inflationary pressures in the last few months due to the war in Iran which made today’s hike inevitable.
Indeed, there is growing evidence of further inflation in the pipeline with PPI surging from -3.0% in February to 4.9% in April, which is probably a key reason that the ECB raised its forecast for core inflation to average 2.5% in 2026 and 2027, up from 2.3% and 2.2% as the press release stated that ECB staff now see higher energy prices feeding into food, goods and services inflation over the forecast horizon. President Lagarde struck an even more hawkish tone in the press conference, stating that “the main risk would have been not to take this decision”, batting away accusations that the ECB had rushed into rate hikes and might cause unnecessary weakness in the economy.
The ECB were always likely to hike rates, even in its new mild scenario it saw inflation peaking at 3.2% and core inflation above target through most of 2027 which is why President Lagarde described the decision as “robust” and “necessary across all four scenarios”.
Rate hikes in the summer
Further ahead, The ECB is unlikely to feel that “one and done” is sufficient protection against those rising inflation risks for a few reasons.
First, the ECB’s scenarios were conditioned on three rate hikes this year, which means the ECB is unlikely to feel that one hike would be enough to deal with the current overshoot and return inflation to target.
Second, President Lagarde was keen to discount the contraction in Q1, as it was driven by Irish GDP falling 12.1% which is distorted by multinational activities. So, the Governing Council will be comfortable that growth has held up so far, despite business surveys pointing to contraction in Q2, with GDP excluding Ireland forecast to rise 0.9% this year. This would only be a little slower than in 2025 even if the ECB hikes rates three times. We think that will give the Governing Council enough cover to hike rates a second time, but it may need to be more considered beyond that if the weakness in the survey data persists.
Third, we think the ECB estimates neutral – where interest rates are neither weighing on or supporting activity - to be around 2-2.5%, at the very least they will want to get the deposit rate to the upper end of this estimate to ensure policy is at least mildly weighing on inflation.
On balance, we think September looks like the most likely date for another rate hike, as the Governing Council continued to emphasise that the impact would “depend on the intensity and duration of the energy price shock”, which sounds like the ECB will want to see more than another months’ worth of data before hiking further as they aren’t discounting the chance of a deal that can open the Strait of Hormuz, which would allow energy prices to fall back.
That said, we aren’t ruling out a move in July given the hawkish tone of the Council. As Gediminas Šimkus, the member from Lithuania, said in a recent speech that “A second hike is more likely than not. But I do not think we are now in a position to say whether it would be July, September or October”.
In any case, any tightening cycle should be short-lived, the PMIs point to falling output in Q2 and the labour market is much weaker than it was during 2022, when the ECB hiked rates by 450bps. The softer labour market reduces the likelihood of second-round effects from workers bidding up nominal wages in response to higher inflation, which should mean any second-round effects are limited. Indeed, compensation per employee, the broadest measure of euro area pay growth, slowed to 3.4% in Q1 and will reach 3.0% - the level consistent with 2.0% inflation – in Q4 2026 in the Governing Council’s baseline.
Ultimately, policy moves beyond June will depend on how the war with Iran unfolds. But we think energy prices would need to rise much further to warrant more than two rate hikes. Indeed, financial markets have pared back their expectation for three rate hikes down to two after yesterday’s meeting, as our chart below shows, which we think looks more reasonable as the ECB will need to be careful about unnecessarily weighing on activity despite higher inflation.
