ECB to pause rate hikes but signal more may be needed

Key facts

• The European Central Bank is widely expected to pause its interest rate hikes at its upcoming meeting.
• However, the bank is likely to signal that further rate increases may be necessary in September.
• Rising energy prices, driven by Middle East conflict, are a key concern for policymakers.
• Current data on prices, wages, and economic activity suggest a pause is warranted.
• The absence of significant second-round effects from energy price spikes on wages is a key factor for patience.
• Potential for renewed upward pressure on food prices due to summer weather and El Niño is a risk.

The European Central Bank is poised to maintain its current interest rates this Thursday, marking a pause in its aggressive hiking cycle. This decision comes amid a complex economic landscape where recent benign inflation data and easing wage pressures suggest a breather is warranted. However, the central bank is expected to maintain a hawkish stance, leaving the door open for future rate increases, particularly in September, as a resurgence in oil prices due to Middle East conflict poses a renewed threat to price stability.

Analysts at Oxford Economics anticipate a 'hawkish pause,' indicating that while current data might narrowly favor additional tightening, the ECB will keep its options open. Financial markets are pricing in between two and three more rate hikes, a scenario that most economists believe is excessive given the projected inflation trajectory. Jens Eisenschmidt of Morgan Stanley suggests that with inflation expected to be near target next year, more than two hikes would be unnecessary and could lead to a cut sooner rather than later.

ECB President Christine Lagarde is expected to navigate a delicate balance, signaling continued vigilance against inflation while avoiding the stoking of market expectations that are already largely priced in. A key reason for the ECB's potential patience is the lack of significant second-round effects from the energy price shock, such as a wage-price spiral. Wage growth has been easing, the labor market is softening, and firms anticipate muted pay pressures. Consumers have also scaled back their inflation expectations.

Despite these moderating factors, policymakers remain concerned that second-round effects could still materialize, necessitating readiness to act. Furthermore, adverse weather conditions across Europe, including a potential impact on crops from heatwaves and El Niño, could lead to renewed upward pressure on food prices. Low water levels on key rivers also pose a risk to shipping and supply chains, potentially exacerbating inflationary pressures.