ECB: On hold, but a September hike likely if things don’t improve

The European Central Bank (ECB) has kept the deposit rate unchanged at 2.25%, after hiking in June. The decision was unanimous, although according to ECB President Christine Lagarde, some members considered the possibility of hiking rates.

The statement noted that the outlook for energy prices is currently close to the June baseline forecast (although the bank sees risks to the inflation outlook as on the upside). Again, it will continue to follow a data-dependent and meeting-by-meeting approach, while the statement noted that it will be “closely monitoring the intensity and duration” of the energy shock, as well as indirect and second-round effects.

Our impression is that if things stay as they are in terms of oil prices and the Middle East that the ECB will implement a rate hike in September.

Our impression is that if things stay as they are in terms of oil prices and the Middle East that the ECB will implement a rate hike in September. We note the Bloomberg story immediately post-meeting consistent with that, reporting that according to people “familiar with the situation” that “based on today’s information and data” a 25bps rate rise “will be needed” to contain inflation pressure.

Back to the baseline?

During the press conference, Lagarde said that there is a lot of back to the baseline in the situation they are facing and in her opening statement Lagarde again described risks to the upside for inflation (having said at Sintra only a few weeks ago that risks were becoming more balanced as oil prices fell). The baseline scenario is conditioned on oil prices averaging $97 per barrel in 2026 (very close to today’s price), and a market implied path of two further rate hikes. In this scenario, inflation peaks at 3.0% in 2026, before returning near target in 2027.

Watching for second round effects

The ECB continues to monitor the risk of second-round effects closely and thinks that the impact of the energy shock has yet to fully play out. Lagarde noted that medium-term measures of inflation expectations remain well anchored, while the ECB’s wage trackers and surveys provide no evidence of second-round effects currently materialising. That said, Lagarde highlighted that the council remains “particularly attentive” to the risk of second-round effects and is “scrutinising” the incoming data for signs of broader inflation risks. 

Consistent with a hike in September… if things stay as they are (or worsen)

As expected, there was no sense that Lagarde was committing to anything, but there was a sense, we think, that if things stay much as they are then a hike is likely in September. 

• Despite the lack of second round effects, Lagarde mentioned that they were seeing indirect effects.
• She also indicated that the market reaction to developments suggested a firm understanding of the ECB’s reaction function. In that context it is important to note that, as of yesterday, the market was almost fully priced for a rate hike by September, with another hike priced by early 2027.
• Note too that, in response to a question, she said that the council did not take Thursday morning’s developments (in terms of Houthi involvement) into account in its decision (given the timing of the news).

However, Lagarde did also emphasise the large amount of data that they would receive before the September meeting (and “the burden of proof is on the data” she said of the September decision). Clearly there is plenty of opportunity for the situation in the Middle East and energy prices to look very different by the time of that meeting (10th September).

As Lagarde put it, the longer energy prices stay high the more likely they are to drive up broader inflation through indirect and second round effects.

If, before then, we see a significant fall in oil prices (again) and the data continues to show a lack of second-round effects, then we would expect our baseline forecast to hold, and for the ECB to keep rates where they are. But if things look pretty much as they do now, we would expect a rate hike. The durability of the shock matters for the central bank’s decision-making. As Lagarde put it, the longer energy prices stay high the more likely they are to drive up broader inflation through indirect and second round effects.

Lagarde once again confirmed she will stay on…for a few months at least

Lagarde was again asked to comment on whether she was planning on leaving the ECB ahead of the end of her term. She said that “you are not going to see the back of me before 2027” and that (again) “when there are clouds on the horizon, the captain stays on the ship.” We’d interpret that as suggesting that she will stay on at least until the end of the year but longer if the crisis in the Middle East is ongoing.

Fund manager view: The Burden of Proof is on Data

At its previous meeting six weeks ago, the European Central Bank (ECB) Governing Council increased key policy rates by 25bps, as expected and the market reaction was somewhat muted.

Going into this meeting, markets assigned little probability to a further rate increase in July and this proved correct. Rates were kept on hold, and the focus switched to any signals on the likelihood of a hike in September. What will tip the balance come September?; is the burden of proof on the more hawkish members of the committee to justify that second hike, or is it on the doves to argue the case for keeping rates on hold? Lagarde was clear: the burden of proof is on the data.

The recent sell-off in European government bond markets has seen two-year bund yields approach 2.9%, a level last seen mid-2024, and whilst 10-year bund yields are at levels last seen in 2011, the yield differential between the two points since the beginning of the conflict at the end of February, has compressed by around 32bps (0.32%). Despite the ECB stressing, once again, their commitment to following a data-dependent and meeting by meeting approach to determining the appropriate monetary policy stance,  the market is now close to fully pricing two further hikes in 2026 and a further hike in 2028. We feel that this is overdone and see value in shorter dated European Bonds at these levels. Volatility remains elevated and  much like Lagarde’s assessment of the efforts of ECB staff, we will remain agile to take advantage of these fast-moving markets.

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