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The European Central Bank (ECB) will almost certainly keep interest rates on hold at next week’s meeting. Energy prices have fallen back from their recent peaks. This has removed the need for an immediate response and given the Governing Council space to wait for uncertainty to fade.
Further ahead, the ECB is likely to raise rates once, possibly twice, from June. That’s unless there’s a permanent ceasefire that, crucially, re-opens the Strait of Hormuz. Any tightening cycle is likely to be short and shallow because the labour market is softer than in 2022 and demand is much weaker, which lower the risk of second-round effects from wage bargaining.
April ECB interest rate hold all but guaranteed
We expect the ECB to hold interest rates again at next week’s meeting as it continues to wait and see if peace talks between the US and Iran lead to a definite end to the crisis.
ECB President Christine Lagarde said this week: “The stop-start nature of the conflict – war, ceasefire, peace talks, their collapse, a naval blockade, its lifting, its reinstatement – makes it exceptionally hard to gauge the duration and depth of the consequences.” This makes it almost a sure bet that the Governing Council will vote to keep its main deposit rate at 2% in April as it awaits more clarity.
The data since the ECB’s March meeting also won’t be enough to convince rate-setters to hike rates in April. Eurozone inflation surged to 2.6% in March from 1.9% in February and was driven entirely by energy prices. Core inflation, which strips out energy and food, dropped to 2.3% from 2.4%, suggesting that underlying price pressures were still easing as the conflict erupted.
At the same time, the PMIs collapsed to 48.6 in April, a 17-month low, raising the risk that the eurozone economy contracts in Q2. Weakening underlying price pressures and slower growth both mean that the ECB can afford to hold rates in April, even if it decides to raise rates later this year.
In any case, the ECB will want to see more than just one month of inflation data before making any upward move to rates. Last Friday, Governing Council member Alexander Demarco confirmed this view, stating that “given higher uncertainty at the moment, June is the more natural horizon for judgement”.
June ECB rate hike looks increasingly likely
Ultimately, it’s still too soon for the ECB to judge whether the rise in energy prices will prove more than just a temporary blip or feed through into greater inflation persistence. The ECB has been more successful at returning inflation to 2% than other central banks, which has kept inflation expectations well-anchored. This reconfirms there’s little need for the Governing Council to rush into rate increases at next week’s meeting. Indeed, ECB Executive Board member Isabel Schnabel, one of the Governing Council’s most hawkish members, said as much earlier this month in that the ECB “can afford to take the time that is needed in order to analyse the character of this shock…We do not need to rush into it.”
Further ahead, we think risks are clearly skewed towards rate rises – especially as the ECB is keen to avoid a repeat of the 2022 energy shock.
At its March meeting, the ECB laid out three scenarios for energy prices: a baseline, an adverse and a severe scenario. In the baseline scenario, oil prices were assumed to average $90 per barrel (pb) in Q2, while gas prices would be €50/MWh. Oil prices are currently around $100pb, above the baseline, but gas prices are below. It means the ECB may not be in a position yet where it needs to aggressively raise rates.
However, inflation will still overshoot the ECB’s target if energy prices remain at these levels. Laying out the ECB’s response in March, President Lagarde reiterated that where there’s “a large, though not-too-persistent overshoot of our target, some measured adjustment of policy could be warranted”. Given this baseline forecast was conditioned on 3-month Euribor rates (the rate eurozone banks lend to each other on 3-month maturities) reaching 2.6%, that would imply two rate rises this year.
Moreover, if the Strait of Hormuz is still closed in June, then we expect energy prices will head towards the ECB’s adverse scenario. This would seal the deal on the ECB hiking rates in June.
That said, any tightening cycle will likely be short. The labour market is cooler now than it was back in 2022. The vacancy rate is currently 2.2% compared to a peak of 3.3% in 2022. Granted, the unemployment rate at 6.2% is close to an all-time low, but the euro area is no longer experiencing “acute labour shortages”, as President Lagarde put it. This reduces the likelihood of second-round effects from workers bidding up nominal wages as they did in 2022 in response to higher inflation. Similarly, firms will struggle to pass on higher input costs through pricing against a backdrop of weaker demand. That means we think the ECB will probably only increase rates once or twice this year, unless the conflict escalates and severe second-round effects seem likely.
All told, the ECB will remain on hold in April. If there has not been a permanent solution to the crisis that sees the Strait of Hormuz open by June, then the ECB will likely hike rates this summer to ensure inflation returns to 2%.
