ECB set to pause rate hikes but signal more may be needed

The European Central Bank is poised to maintain its current interest rates on Thursday, but policymakers are likely to keep the door ajar for a potential September hike. This cautious approach comes as a recent surge in energy prices, particularly oil, threatens to reignite inflationary pressures across the eurozone.

While the ECB delivered a rate increase in June and hinted at further tightening, a series of moderate inflation and economic data releases in the intervening weeks had lessened the immediate urgency. However, with oil prices climbing back above $90 a barrel amid ongoing conflict in the Middle East, the central bank may feel compelled to act again by autumn to prevent the energy shock from triggering a wider price spiral.

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We think the ECB will enter a hawkish pause. Current data would narrowly favour additional policy tightening down the line, in line with the June forecast and broadly validating market pricing.

Analysts at Oxford Economics predict a "hawkish pause," suggesting that current data "would narrowly favour additional policy tightening down the line." Financial markets are pricing in two to three more rate hikes, with the first expected by October. Yet, many economists argue that the eurozone's economic fundamentals do not warrant such aggressive tightening. Morgan Stanley's Jens Eisenschmidt believes that even with current oil prices, inflation will be near target next year, making further hikes beyond two unnecessary.

ECB President Christine Lagarde is expected to navigate a delicate path, signaling continued vigilance against price pressures while avoiding the creation of excessive market expectations. A key factor allowing the ECB to exercise patience is the absence of the feared "second-round effects" of energy price increases. Despite high energy costs, wage growth is easing, the labor market is relatively soft, and businesses anticipate lower pay pressures. Consumer inflation expectations have also moderated, with little evidence of a wage-price spiral taking hold.

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Even with the current oil price, inflation will be just about at target next year, moderately undershooting later in the year. If you believe in that forecast, then there is no reason to hike more than twice.