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The European Central Bank (ECB) is likely to leave interest rates unchanged at 2.5% on Thursday. With little evidence of second-round inflation effects, the Governing Council is unlikely to feel compelled to deliver consecutive rate hikes.
However, we expect the ECB to raise rates again in December, pushing policy modestly into restrictive territory. Beyond that, the outlook will depend heavily on energy markets. If tensions ease and prices normalise, policymakers may pause.
But low European gas storage, geopolitical risks and El Niño-related pressure on food prices suggest the balance of risks still points towards further tightening.
Rates on hold in October
We expect the ECB to keep rates on hold in October despite the renewed rise in energy prices, which are now slightly above the ECB's adverse scenario and have pushed headline inflation to 3.8%, its highest level since 2023.
We see three reasons why the ECB is likely to remain on hold. First, there is still little evidence that higher energy prices are feeding into broader inflation. Core inflation rose to 2.5% in September but is only 0.1 percentage points higher than before the Iran conflict. In a recent IMF speech, President Lagarde noted that "underlying inflation measures remained broadly stable in September, and wages have so far shown no material response to the energy shock". That gives policymakers scope to wait until December, when updated forecasts will provide a clearer picture of the shock's persistence and economic impact.
Second, the sharp rise in bond yields, particularly in France, has materially tightened financial conditions since the ECB's last meeting. Tighter financing conditions should weigh on growth and in turn inflation, reducing the need for an immediate rate increase. What’s more, the ECB will be wary of adding to the pressure on a clearly stressed debt market in some countries. The market is pricing in virtually no chance of a rate hike, so delivering one would be a be a shock that would add to market stress.
Third, the bar for consecutive rate hikes remains high. Mārtiņš Kazāks recently argued that "there isn't any immediate need to rush on rates", while President Lagarde has stressed that “the energy shock is too large to “look through” but a measured response remains appropriate to keep inflation in check.”
Taken together, these factors suggest the Governing Council think they can afford to wait and will hold rates at next week’s meeting.
One more rate hike this year
Further ahead, we think the ECB will probably opt for another hike in December.
Energy prices are now above the ECB's adverse scenario. The longer they remain elevated, the greater the risk that higher costs feed through into wages and broader prices. That increases the likelihood that policymakers feel that further tightening is necessary to lean against inflation pressures, even if second-round effects are not yet fully visible. In other words, the ECB may not be comfortable just reacting to second-round effects but will want to limit the emergence of them in the first place. That will require further rate hikes.
In addition, ECB research suggests a strong El Niño event could increase crop prices by around 9%, adding directly to inflation. Because food and energy prices are among the most visible prices households face, persistent increases could also lift inflation expectations and influence wage and pricing decisions. At the same time, European gas storage remains relatively low, leaving energy markets vulnerable to another spike if winter temperatures are colder than expected. In any event, inflation is likely to remain higher over the next couple of years than previously expected.
Finally, policymakers seem to agree that the neutral rate, where monetary policy is neither stimulative nor restrictive, is somewhere between 2% and 2.5%. We expect most Governing Council members to favour at least one further increase, taking the deposit rate to 2.75% and ensuring policy is slightly in restrictive territory.
That said, labour market conditions remain softer than in 2022. As a result, we do not expect a sharp acceleration in underlying inflation. A weaker jobs market should limit workers' ability to secure large pay rises, reducing the risk of a wage-price spiral.
Overall, we expect the ECB to remain on hold in October before delivering another rate hike in December. Beyond that, the policy outlook will depend largely on developments in energy markets. Even so, any further tightening is likely to be limited compared with 2022 given the weaker labour market and tighter starting point for monetary policy.
