ECB: on hold in October, but at least one more hike on the way

As expected, the European Central Bank kept rates on hold in October. There is currently little evidence of second-round effects and the bond market stress in France means the ECB was always unlikely to surprise markets with a consecutive rate hike. That said, we still think the ECB will raise rates once more before President Lagard leaves office in February, pushing policy into mildly restrictive territory and hopefully giving her successor some breathing space before considering further hikes.

On hold in October 

The ECB kept rates on hold at 2.5% in October for a couple of reasons.

First, the press release reiterated President Lagarde’s previous comments that underlying inflation remains broadly stable and that wages have so far shown no material response to the energy shock. Against that backdrop, there was no need for the Governing Council to rush into another rate rise today.

Second, the sharp rise in bond yields, especially in France, has materially tightened financial conditions. Those higher costs for households and firms will drag on growth and therefore inflation. That means financial markets are doing some of the ECB’s work for it, giving the Governing Council more time to better ascertain the impact of the energy shock. What’s more, financial markets were pricing in virtually no chance of a rate hike before the meeting, so the ECB was likely wary of adding to the pressure on a clearly stressed debt market in some countries. A surprise rate hike would have been another shock that would have added to market stress.

Taken together, these factors mean the Governing Council had no need to rush into back-to-back rate hikes in October. 

At least one more rate hike to come

Further ahead, we still think the ECB will opt for another hike in December.

Energy prices are above the ECB’s adverse scenario from September. The longer they stay elevated, the greater the risk that higher costs spread into wages and a wider range of prices. Policymakers are unlikely to wait for those second-round effects to become entrenched before acting. A December rise would therefore be an insurance move: modest enough to acknowledge the weaker economy, but early enough to reduce the risk of another inflation shock becoming persistent.

Other pressures are also building. El Niño is likely to lift food inflation in the coming months, while chip shortages linked to strong AI-related demand could add to energy-driven pressure on core goods prices. Food and energy costs are especially visible to households. Further increases could lift inflation expectations, strengthen wage demands and encourage firms to raise prices.

Furthermore, 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.

Moreover, policymakers appear to place the neutral rate, at which monetary policy neither stimulates nor restrains the economy, at roughly 2% to 2.5%. One further increase would take the deposit rate to 2.75%, putting policy mildly into restrictive territory. We expect that argument to command a majority on the Governing Council.

Admittedly, the case for aggressive tightening remains weaker than in 2022. Compensation per employee growth eased to 3.3% in Q2, which is around the level the ECB thinks is consistent with 2% inflation. 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.

In any case, inflation will reach 4% in the coming months so we expect the ECB to hike again in December to ensure policy is mildly restrictive. Beyond this, if energy prices fall back sharply policymakers can pause, but the risks are clearly tilted towards more hikes in 2027. 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.