The European Central Bank is set to raise interest rates on Thursday with market odds placing the probability of a quarter-point increase at near certainty, according to Euronews analysis. The decision would lift the ECB's deposit rate from 2.25% to 2.5%, marking another step in the central bank's monetary tightening cycle that began in June following the energy shock from the Iran war. While the rate hike itself appears all but assured, the underlying rationale is more complex and contested than headline inflation figures might suggest.
August's eurozone inflation data reached 3.3%, up from 2.9% in July and the highest level since September 2023, driven largely by a surge in energy inflation to 14.3% from 10.3%. This data prompted ECB President Christine Lagarde to signal the likelihood of a September move following the bank's June rate increase and July pause. However, a closer examination of inflation components reveals a different narrative beneath the surface.
Core inflation, which excludes energy, food, alcohol and tobacco, actually declined to 2.4% from 2.5% in the previous month. Services inflation, which is considered the most reliable indicator of wages and domestic demand pressures, fell to 3% from 3.3%. These figures suggest that the expensive energy is not spreading into other parts of the economy through so-called "second-round effects," an absence economists view as the strongest argument against tightening monetary policy.
Research published by ECB economists on Tuesday supports this distinction. Their analysis found that adverse energy supply factors, driven by geopolitical tensions, accounted for approximately 90% of the rise in energy inflation between January and May. The economists noted that this differs markedly from the 2021-22 surge, which resulted from a combination of unprecedented supply and demand-side factors, explaining why the ECB responded with forceful and persistent rate increases at that time rather than the gradual approach now being pursued.
The regional variation across eurozone member states further underscores the uneven nature of current inflation pressures. August inflation rates ranged from 4.5% in Spain to 2.9% in Germany and 2.7% in France. These three economies face the same energy shock yet experience markedly different inflation outcomes, all subject to a single ECB interest rate set in Frankfurt.
Economic growth presents another complication for the ECB's policy calculus. The eurozone has demonstrated greater resilience than many analysts anticipated. Research from ING attributes this partly to favorable geopolitical factors affecting competitors, particularly Asian economies suffering more severely from the closure of the Strait of Hormuz, and partly to fiscal stimulus measures.
ING characterizes Thursday's expected rate increase as an "insurance rate hike" or "dovish rate hike," noting that even at 2.5%, the deposit rate remains within the range the ECB itself considers neutral to monetary policy. Moving further would signal a shift toward restrictive policy, a different policy judgment entirely. The ECB's decisions do not occur in isolation.
The Federal Reserve meets September 15-16, with Chair Kevin Warsh using his recent Jackson Hole address to argue that financial conditions are not restrictive and underlying inflation has not improved. Before Warsh's remarks, markets priced the probability of a US rate increase at roughly one in three, but this has shifted to approximately 60% odds of the Fed raising its target range from 3.5%-3.75% to 3.75%-4%. The Bank of Japan will meet September 17-18, with markets pricing an 80% to 90% probability of a move to 1.25%.
In contrast, the Bank of England is expected to hold rates at 3.75% on September 17, maintaining its significantly higher rate relative to other major central banks. The prospect of synchronized global rate increases carries implications for the euro. If the Federal Reserve were to hike while the ECB held steady, the dollar would strengthen against the euro.
While a weaker euro would enhance the competitiveness of European exports, it would also increase import costs. Critically, since oil and gas are priced in dollars, euro weakness would push up precisely the energy costs driving the inflation problem the ECB is attempting to address. On balance, the consensus appears certain regarding a September ECB rate hike.
However, analysts suggest the central bank faces an enduring dilemma: raising borrowing costs against an inflation it cannot directly reach through monetary policy alone, while simultaneously withdrawing economic support from an economy that could still benefit from accommodative conditions. The decision represents an awkward compromise between market expectations and the mixed signals embedded in the actual inflation data.
Source: euronews.com