ECB at a Crossroads: Hormuz Holds the Key to What Comes Next

The European Central Bank is likely to deliver a 25 basis-point rate hike at its meeting concluding today. But while the direction of travel may be clear for now, the path beyond September is anything but.

The ECB is likely to keep its powder dry beyond today, with the path thereafter determined by how the economy and, above all, inflation respond to the renewed energy shock. The key message from the Governing Council is therefore likely to be hawkish: further hike(s) may be warranted if inflation risks intensify, but policymakers will want to retain flexibility rather than pre-commit to any specific policy path.

There is only modest evidence so far that inflation expectations are becoming less firmly anchored, although there may be growing concern that second-round effects may eventually turn a temporary energy shock into a more persistent inflation problem. The challenge for the ECB is that the economy has so far proven more resilient than expected, making an upside revision to its growth projections probable. Output rose more than anticipated during the second quarter, and business surveys are suggesting solid momentum ahead.

That resilience matters. A weaker economy would give policymakers more room to look through an energy-driven inflation spike. A more robust economy, by contrast, makes it harder to assume that higher energy prices may simply wash through absent affecting wages, services prices and broader inflation behaviour.

Euro area headline inflation rose to 3.3% year on year last month ( Figure 1 ), although the easing in core inflation to 2.4% does offer some reassurance. Underlying inflation measures have stayed comparatively moderate, wage pressures are still contained and there is, as yet, only sparse evidence that the energy shock is generating widespread second-round effects.

Figure 1. Euro area headline inflation rose last month

Euro area headline and core harmonised index of consumer prices, annual rates of change, %

But the ECB will be watching the direction of travel rather than simply the numbers today.

High energy prices, stronger forward-looking wage trackers and somewhat elevated market-based inflation expectations all suggest greater upside risk. As such, the tone of the press conference today is probable to be more important than the rate decision itself. A 25bp hike is increasingly well telegraphed; what markets will be listening for is how seriously policymakers see the possibility of having to do more.