ECB: One and done? Probably not

As expected, the European Central Bank (ECB) has hiked 25bp, raising the deposit rate to 2.25%. The decision was unanimous and, according to President Christine Lagarde, no alternative proposal was discussed.

Key in the statement was the following: “With today’s decision, the governing council remains well positioned to navigate the uncertainty caused by the war.” Again, the bank will follow a data dependent, meeting-by-meeting approach. There was nothing in the way of forward guidance in that sense and the impression from Lagarde’s comments and the statement was that this was not a hike made with a clear presumption of needing to do more.

That said, the new staff baseline forecast for core inflation is above 2% in 2028 (admittedly headline inflation is at the 2.0% target); the bank’s forecasts are also already conditioned on the market implied path for interest rates which assumes three rather than only one rate hike; risks to inflation are still described as on the upside; and the bank already sees the effect of the conflict on inflation as broadening out.

Unless the conflict ends quickly and the Strait of Hormuz opens soon, we are happy assuming that the ECB will hike again.

Unless the conflict ends quickly and the Strait of Hormuz opens soon, we are happy assuming that the ECB will hike again and continue to pencil in another 25bp rate rise at either the July or September meeting with a good chance of a third hike if things don’t improve soon.

During the press conference, President Lagarde outlined the following factors underpinning today’s rate hike decision: 

• Signs of indirect inflation: Lagarde said the ECB was starting to see inflation “broadening out throughout the economy”, capturing both direct and indirect price effects. For now, the ECB is not seeing evidence of second-round effects, although that typically takes some time to feed through.  
• Near term inflation expectations are rising: Lagarde highlighted that short-term inflation expectations have increased across market, business surveys and consumer measures, although medium-term inflation expectations remained anchored. Notably though, the ECB has removed its previous comment that “longer-term inflation expectations remain well anchored” from the monetary policy statement.
• Rate hike warranted across all scenarios: Lagarde underscored that today’s rate hike decision remained robust even in the ‘milder’ of its three alternative scenarios (which factors a more optimistic outlook for energy prices). 

Core messaging unchanged

Beyond that, the core messaging was largely unchanged, highlighting upside risk to inflation, downside risk to growth and the committee taking a meeting by meeting, data dependent approach. When evaluating future developments, Lagarde said they will be watching closely for indirect effects and any potential second-round effects. 

Lagarde would not call it an insurance hike, but neither was it a ‘forceful’ one

President Lagarde did not want to give the impression that this was somehow a precautionary/’just in case’ rate hike, but that it was necessary given the factors above and given the uncertainty they are navigating. She, also, however, referenced her speech earlier this year where she said that if inflation was expected to deviate durably and significantly above target a forceful response would be required; she said that today’s decision was not a “forceful” one. 

We would not expect a 25bp alone to do much direct damage to the growth outlook in a Euro area context.

Policy mistake?

Unsurprisingly, Lagarde strongly defended the ECB against suggestions that the hike would be bad for growth and a mistake, saying that their mandate was price stability, and it would be worse to let inflation run and then require more policy action to get it back on track. We would not expect a 25bp alone to do much direct damage to the growth outlook in a Euro area context.  

Updated baseline and economic scenarios 

Following an increase in oil prices, the ECB has downgraded its growth outlook while revising up its inflation projections since March. The baseline forecast now sees inflation average 3.0% in 2026 (up from 2.6% in March) and 2.3% in 2027 (up from 2.0% in March), before returning to the 2% target in 2028. GDP growth has been revised down to 0.8% in 2026 (from 0.9% in March) and 1.2% in 2027 (from 1.3% in March).  

Three alternative scenarios

The ECB has extended its scenario analysis to include a more optimistic, ‘milder’ scenario as well as maintaining an ‘adverse’ and ‘severe’ scenario. All scenarios are conditioned on the market implied path for the deposit rate, which includes three hikes.  

The three scenarios are differentiated by the energy price paths and transmission of the shock throughout the economy.  

• Milder scenario: Energy prices follow the 25th percentile of the market implied probability distribution, with the same indirect and second-round inflation effects as the baseline.
• Adverse scenario: Energy prices follow the 75th percentile of the market implied probability distribution, with stronger indirect and second-round inflation effects than the baseline.
• Severe scenario: Energy prices follow the 95th percentile of the market implied probability distribution, with stronger indirect and second-round inflation effects than the adverse scenario.

The milder scenario sees inflation peak at 3.2% in 2026Q2, falling below target in 2027Q2 until the end of 2028. The adverse scenario sees inflation peak at 4.1% in 2026Q4, remaining above target for the entire forecast horizon. Likewise, the severe scenario sees inflation peak at 6.3% in 2027Q3, remaining above target for the entire forecast horizon.  

In terms of growth, none of the scenarios include a calendar year of growth below 0.4% in the euro area (absent any further monetary tightening beyond the market implied path). GDP growth in the milder scenario recovers more robustly than the baseline, while the adverse and severe scenario see growth slow considerably more than the baseline in 2026 and 2027.  

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