European Central Bank Expected to 'Pause Hawkish' Tonight, Door for Autumn Rate Hike Remains Open

The European Central Bank is almost certain to "hold steady" tonight. However, the shadow of rising inflation may force decision-makers to leave room for a rate hike in September. Lagarde faces a difficult balancing act amid slowing wage growth and a weak economy.

At 8:15 PM Beijing time on Thursday, the European Central Bank will announce its interest rate decision. The market widely expects the central bank to keep rates unchanged while leaving ample room for another hike in September, as conflicts in the Middle East have pushed oil prices back above $90 per barrel, adding new upward pressure on inflation in the Eurozone.

In response to energy shocks, the European Central Bank raised rates by 25 basis points in June and hinted at further tightening. However, the price, wage, economic activity, and inflation expectation data released in the following weeks have been relatively mild, reducing the necessity for the ECB to act again.

Oliver Rakau from Oxford Economics stated, "We believe the ECB will enter a 'hawkish pause' state." He noted that the latest data barely supports further tightening of policy in the future.

"Current data will barely support further tightening of policy in the future, consistent with the June forecast and largely confirming market pricing," Rakau said.

Financial markets currently expect the ECB to raise rates two to three more times, with the market fully pricing in another hike before the end of September, and the next one before the end of April next year. The role of oil price changes in this market pricing is greater than that of economic fundamentals. Bank of America expects a 25 basis point hike in September due to the rebound in energy prices.

However, most economists believe that the Eurozone, consisting of 21 countries, does not need such significant tightening to control inflation. A team of analysts at Bank of America pointed out in a recent report that they have not seen signs of policy tightening recently.

They stated, "We firmly believe that whether the ECB raises rates once or twice this year, by the end of 2027, the policy rate will reach a maximum of only 2%. Why? We still believe that the duration of inflation is far lower than expected. The scale of the current energy price shock is completely different from that of 2022."

Jens Eisenschmidt from Morgan Stanley also stated, "Even at current oil prices, inflation rates will likely reach target levels next year and be moderately below target later this year. If you believe that forecast, then there is no reason to raise rates more than twice."

He added, "At a level of 2.5%, deposit rates will have a moderate restrictive effect, so if you are approaching the target, it is easy to find reasonable grounds for cutting rates from that level."

Wages and Service Prices Have Not Created Second-Round Effects

Half an hour after the interest rate decision is announced, at 8:45 PM Beijing time on Thursday, Lagarde will hold a press conference. At that time, she may need to find a balance between inflation risks and mild data: indicating that decision-makers are still concerned about price pressures, and further tightening is still on the agenda, while avoiding reinforcing rate hike expectations that have already been heavily priced in by the market.

The ECB can afford to be patient for now, partly because the "second-round effects" triggered by rising energy prices have not yet emerged. Rising energy costs typically push up the prices of goods and services and prompt workers to demand higher wages.

If wages and prices push each other, a wage-price spiral may form. Current wage and labor market data have not shown evidence of this process.

Wage growth in the Eurozone continues to slow, and the labor market is relatively weak, particularly evident in Germany, the largest economy. Companies surveyed by the ECB also expect wage pressures to further diminish.

Consumers have already lowered their price expectations, and detailed data show almost no evidence of "second-round effects." The annual inflation rate in the Eurozone in June was 2.8%, down from 3.2% in May and below the previous expectation of 3%. Citigroup predicts that the Eurozone's Purchasing Managers' Index (PMI) will show "moderate growth" in July. Due to rising fuel prices, Citigroup expects the growth of the consumer confidence index to stagnate that month.

Trade tensions, high energy costs, and other factors will continue to suppress the Eurozone's industry, which may face ongoing difficulties in the coming years, putting downward pressure on labor demand.

High Temperatures and Food Prices Pose New Inflation Risks

ECB decision-makers still believe that even if the scale of second-round effects is small and their emergence is delayed, related pressures may eventually arrive. Therefore, the central bank needs to retain the ability to act again.

This month, much of Europe has experienced a scorching summer, and crops may have been damaged, posing a risk of rising food prices. Low water levels in key rivers may also lead to shipping bottlenecks.

Food inflation has generally declined in recent months, primarily due to weakening prices of commodities such as sugar, cocoa, and coffee. However, unusually high temperatures and the El Niño phenomenon may change this trend.

Barclays stated in a report, "Although food inflation has generally been on a downward trend in recent months, reflecting the softening prices of commodities such as sugar, cocoa, and coffee, the unusually warm summer in Europe combined with the impact of El Niño may put food prices back under upward pressure."

If energy shocks spread to other goods, services, and wages, the ECB may take action again in the autumn. The focus of Thursday's meeting will be to maintain stable interest rates while clarifying that a rate hike in September remains a policy option.

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