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The European Central Bank (ECB) is likely to be the next major central bank to raise interest rates at its meeting next week. The ECB is worried about second-round effects from the jump in fuel prices given that the bloc has only just come out of the last energy shock. With the deposit rate at just 2%, there is scope to increase rates to lean against rising inflation without damaging growth significantly.
Further ahead, the outlook is less clear and depends on whether the Strait of Hormuz is opened soon, but on balance we think ECB is likely to hike rates again later this year given members general agreement with market pricing and relative unwillingness to ‘look-through’ the energy shock..
June rate hike is all but guaranteed
We expect the ECB to hike rates by 25bps at next week’s meeting as the Governing Council has likely judged that the disruption from the conflict in the Middle East is great enough to warrant a short hiking cycle, despite the recent fall in oil prices.
Indeed, President Lagarde made clear at the last press conference that June would be the “right time” to cast judgement and that “directionally, I know where we’re heading.” That’s a clear signal that interest rates are likely to go higher, given that the Strait of Hormuz is still closed, even if the degree of tightening remains unclear.
Granted, central banks tend to look through supply shocks waiting until policymakers can ascertain the extent to which topline inflation bleeds into the core and inflation expectations begin to be reset higher. However, given the large supply shock impacting the European economy policymakers may not enjoy the luxury of looking through a historic reduction in the supply of oil and refined products and will likely need to hike rates in the near term.
In fact, we think much of the Governing Council have already seen enough, Isabel Schnabel, arguably the most hawkish member of the ECB, stated on Monday that “We can no longer look through this shock. The risk of de-anchoring inflation expectations is rising.” We think the Council is broadly in agreement on a rate hike, Fabio Panetta, who is usually more dovish, also spoke recently adding “The forward-looking picture seems to call for a recalibration of the monetary policy stance."
What’s more, the policy rate is now just 2.0%, significantly lower than in the UK and the US. A modified Taylor rule, which estimates the appropriate level of interest rates given inflation and the unemployment rate, implies that policy is slightly too accommodative for the eurozone in the face of a historic global supply shock that has already raised inflation back above 3.0%. This suggests that it is necessary for the ECB to raise rates to maintain price stability.
All told, we expect a 25bps hike from the ECB next week but the outlook further ahead is not as clear.
Another hike probable
Further ahead, we think the ECB is likely to hike rates a second time this year, but any tightening cycle will be shallow and short-lived compared to in 2022, when the Bank hiked rates by 450bps. That’s because the economy is weaker and labour market looser than in 2022, which significantly reduces the risks of dangerous second-round effects emerging.
For example, the vacancy rate has declined by a third since it peaked in 2022 and the ECB’s
negotiated wages tracker is running at 2.5%, below the 3.0% level that policymakers judge to be
consistent with 2.0% inflation. The softer labour market reduces the likelihood of second-round effects from workers bidding up nominal wages in response to higher inflation, which should help to avoid substantial second-round effects from spilling into core inflation.
That means aggressive rate hikes probably won’t be needed this time, but financial markets are still pricing in two hikes with a risk of a third over the next year. Rather than pushing back against market pricing, given the softer labour market and annual growth the weakest since 2024, President Lagarde has admitted that “our reaction function is well understood”. That’s Central Banker speak for market expectations look in the right ballpark.
Indeed, Gediminas Šimkus, the member from Lithuania, reiterated that market pricing was broadly correct adding 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.”
Of course, 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, as even in the
ECB’s adverse scenario – which energy prices are currently below – headline inflation would return to target in Q2 2027 before undershooting the 2.0% target and focus would shift back towards subdued growth.
