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The European Central Bank (ECB) held rates today as uncertainty over the conflict in the Middle East and its impact on the economy remains too high, leaving the Council in ‘wait and see’ mode. Unless the Strait of Hormuz is opened by June, we expect the ECB to hike rates when it next meets as it is keen to avoid another repeat of the 2022 energy shock. For Ireland, we now expect inflation to average 3.4% this year, which will eat into real incomes. Fortunately, the Irish economy is far better placed to weather the crisis than the rest of Europe as the labour market is strong enough to support a rise in aggregate real incomes and consumers are saving a large portion of their income.
Uncertainty too high to change policy
As expected, the ECB held rates today as uncertainty over both the duration of the conflict in Iran and the impact on the economy is too high for the ECB to change policy. The guidance emphasised that “the upside risks to inflation and downside risks to growth have intensified”, highlighting the Governing Council’s dilemma. A rate hike today was always unlikely with ECB Chief Economist Phillip Lane stating that he “had not seen anything in the last month to overturn information we had at our March meeting”, a view echoed by most officials.
Admittedly, recent data prompted the Council to debate a rate hike at today’s meeting “at length and at depth” which means the bar to hikes may be lower than we initially expected. Indeed, inflation accelerated to 3.0% in April which will have intensified the argument in favour of a hike, but the core slid to 2.2% from 2.3% and growth came in below the ECB’s forecast which means the Council can afford to wait until June as it continues to assess the full impact of the conflict.
Rate hikes in the summer
Further ahead, we expect the ECB to hike rates in June and probably again later this year. President Lagarde confirmed that June would be the “right time” to cast judgement and that “directionally, I know where we’re heading” which we think means that the President is expecting to hike rates this year.
That said, any tightening cycle will be shallow and short-lived compared to in 2022, when the Bank hiked rates by 450bps, as President Lagarde confirmed that the eurozone is “no longer experiencing acute labour shortages”. This reduces the likelihood of second-round effects from workers bidding up nominal wages in response to higher inflation.
Clearly, the risk is that the ECB hikes rates more aggressively than we are currently expecting as the President confirmed that “we are certainly moving away from the baseline”, which increases the likelihood of second-round effects and in turn rate hikes. President Lagarde also admitted that “our reaction function is well understood” rather than pushing back against the current market pricing for almost three rate hikes. On balance, we still think energy prices would need to rise further to warrant more hikes as even in the ECB’s adverse scenario - which is close to current oil prices, but gas prices are more subdued - inflation would return to target in Q2 2027 before undershooting
Ireland far better placed than the rest of Europe
For Ireland, inflation will average 3.4% this year, above our pre-war forecast of just a little above 2.0%. This will eat into household’s real disposable incomes and drag on the domestic economy. The good news is that the labour market is strong enough to support a rise in aggregate real incomes, even if households feel squeezed. At the same time, the savings ratio is elevated at 12.4%, which means consumers will be able to offset some of the impact on spending through lower savings.
What’s more, the government’s energy supports will soften the impact on households and businesses and hence support growth. The government revised up its estimate of the surplus for this year last week, which means these measures would almost certainly be extended and potentially built upon if energy prices haven’t normalised by August when temporary cuts to excise duty were due to expire.
Ultimately, the Irish economy is coming into this crisis in a much stronger position than the rest of Europe. We still expect modified domestic demand (MDD) to grow by around 2.5% this year. The weaker eurozone economy means that even as the ECB hikes into the supply-shock to leave rates at around 2.5%, its focus will probably turn back towards rate cuts in 2027 to support activity.
