ECB needs to manage longer-lasting inflation shock
Click here to open PDF
On 10 September, the ECB raised its policy rate, the deposit rate, by 25 basis points to 2.50%, as expected. As a result, the refinancing rate and the marginal lending rate also increased by 25 basis points each to 2.65% and 2.90% respectively. The decision was accompanied by new forecasts from the ECB economists. Again, there were a total of three alternative scenarios in addition to the baseline scenario (one milder and two more pessimistic). In the base scenario, two things in particular stood out.
First, ECB economists revised their growth forecast upwards for 2026 and 2027 compared with the June projections (for 2026 to 0.9% (+0.1 percentage points) and for 2027 to 1.4% (+0.2 percentage points). Once again, Ireland's GDP distorted these figures. Based on the measure of Ireland's 'modified domestic demand', European growth is expected to be 0.4 percentage points higher at 1.2% in 2026, compared to June forecasts, and unchanged in 2027 from the June forecasts at 1.2%.
Second, it was striking that according to the ECB, both in the baseline scenario, and in all three alternative scenarios, underlying core inflation remains well above the 2% inflation target on a horizon until 2028. In this context, we must take into account the fact that in making these projections, the ECB economists base themselves on market expectations of 19 August for market interest rates and futures prices for commodities. Even then, in addition to an interest rate hike in September, the markets were pricing in two additional rate hikes of 25 basis points each.
Strictly speaking, therefore, the combination of market expectations and ECB models suggests that the path of underlying core inflation in the baseline scenario will not return to the ECB's 2% target quickly enough, even with a peak in the policy rate of around 3%. This is even less the case for the ECB's 'adverse' and 'severe' scenarios, and remarkably not for the milder scenario either, in which energy prices normalise to the downward relatively faster.
ECB sees several causes of higher inflation expectations
The ECB economists see three important determinants for the overly expected development of inflation. First, of course, there is the energy price shock, which is likely to last longer than initially expected. Further geopolitical developments in the Middle East play an important role in this. Second, there is the stronger-than-expected starting point of the projected real GDP growth path in the euro area, which is accompanied by lower unemployment rates and thus potentially stronger wage growth than would otherwise be the case. The currently more favourable growth environment, which was reflected in the growth figure for the second quarter, is partly due to German fiscal stimulus and public investment, but also private investment in AI. Moreover, there was a sharp drop in energy prices in the second quarter after the temporary truce in the Middle East. Third, the ECB expects food price inflation to pick up, starting from a current lower level.
The ECB also indicated that no second-round effects of price increases are yet visible in, for example, its 'wage tracker' indicator. According to the ECB, there are no abnormal developments yet visible in pricing by companies and in wage negotiations. The results of wage negotiations that will be available in mid-June 2027 will probably provide a better picture of this to assess this fundamentally.
'Robust' decision versus 'risk management'
The conclusion is therefore that September's rate hike was obvious, in the words of ECB President Lagarde and chief economist Lane, this was a 'robust decision'. And in fact, in a way, this also applies to additional interest rate hikes that are already included in the ECB's technical assumptions. While Lagarde explained the decision during the press conference and the scenarios were published, market expectations also became somewhat more restrictive and they started to partially price in a third additional rate hike (peaking at 3.25%). This trend has continued in recent days in a highly uncertain geopolitical context, especially after the recent escalation in Yemen and the threats to shipping off the Bab-el-Mandeb Strait.
Two additional rate hikes by the ECB therefore seem reasonable based on the currently available data. Our base case is therefore in line with this. However, as mentioned, there is a high and growing risk that the ECB will not leave it at two additional rate hikes to address the longer-lasting inflation shock. How far the ECB is willing to go will probably be less of a 'robust' decision than much of a part of its risk management. It will then come down to weighing the economic costs of tightening too little in the event of further rising inflation, versus too much tightening in the event of a faster than expected cooling of inflation.
Steeper yield curve does some of the tightening work
When estimating the number of additional rate hikes by the ECB, we should also take into account the fact that the recent sharp steepening of the yield curve via rising long-term real interest rates is already causing financial conditions in the eurozone to tighten.
This higher ten-year German bond yield is the result of several factors. First of all, it reflects a higher inflation expectation that is mainly driven by the energy price shock. But that only explains part of the increase, as real bond yields are rising sharply. This in turn partly reflects the upward revision by financial markets of the ECB's policy rate path, but above all a higher risk premium (term premium). In turn, this higher risk premium is likely to be partly related to higher inflation uncertainty (i.e. the future higher variability of inflation due to more frequent supply shocks), but also to fiscal risks, not only in the euro area, but also outside it, such as in the US.
Since global long-term interest rates (and especially their inherent term premia prices) are highly correlated, European bond yields are also rising due to what is happening in the US and Japan in terms of public finances and politics. Part of the recent interest rate development is therefore an exogenous tightening of financial conditions from a European perspective, which could mean that the ECB would have to tighten less than would otherwise be necessary.
Where is the neutral interest rate, and is that relevant?
Finally, in order to estimate where the ECB wants to go with its policy rate, there is the approach to the neutral rate and the difference with the current policy rate. The ECB is clear about this approach. President Lagarde considers the concept irrelevant for short-term monetary policy (because short-term shocks disturb the economic equilibrium). Chief economist Lane also thinks the concept may be relevant for communication, but not for concrete monetary policy in the short term. His reasoning is that an interest rate hike is a tightening, regardless of the level at which the policy rate is at that moment. Nevertheless, the concept of a 'neutral rate' is useful for estimating where the policy rate would move again after the current shocks have subsided.
Moreover, the ECB indicated that the classic rule of thumb such as the so-called 'Taylor' rule is not really useful in the context of a supply shock. Higher inflation weighs on growth through demand destruction, which makes the appropriate policy response less straightforward than in the case of a classic demand shock.
To sum up, further interest rate hikes by the ECB are on the horizon. However, the uncertainty about exactly how many there will be is currently exceptionally high.