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

One More Hike, Then a Much Harder Call

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.

Hormuz Is Now the ECB’s Swing Factor

On energy prices, we appear to be currently near an ECB severe scenario outlined during the June Governing Council: Brent crude prices around USD 100 a barrel are somewhat worse than an ECB baseline, whereas European gas prices around USD 80 per MWh have climbed into a terrain between adverse and severe scenarios – increasing to levels last seen during late 2022.

The crucial question now may not simply be how high energy prices go, but how long the shock lasts.

As I said on Bloomberg recently, the Strait of Hormuz has become the swing factor for the ECB’s future decision making because a prolonged disruption would turn an energy-price shock into a broader inflation problem.

This is where the ECB’s current dilemma becomes particularly acute. A central bank can look through a temporary energy shock. It cannot afford to look through a persistent one.

If the ceasefire is reinstated and tensions in the Middle East ease, energy markets could stabilise quickly. In that scenario, today’s expected 25bp move could plausibly mark the end of the hiking cycle, leaving the deposit rate thereafter at 2.5% – on the high end of the ECB’s neutral rate range where many policymakers may be uncomfortable going beyond. The ECB could wait thereafter patiently for inflation to return towards target.

That outcome, however, appears to require a meaningful de-escalation in US-Iran tensions inside the coming months.

The Donald Trump government does face increasing pressure to respond, ahead of US midterm elections and as the Federal Reserve itself has come under growing pressure to raise rates if geopolitical escalation continues. A further deterioration in the Middle East would create an uncomfortable feedback loop: higher energy prices would push inflation higher, whereas the prospect of tighter US monetary policy could further tighten global financial conditions.

For the ECB, the consequences could be equally uncomfortable.

If the ceasefire is not reinstated and oil and gas prices stay elevated, the central bank may have little choice but to look beyond September as second-round effects gather momentum and effects on inflation expectations become increasingly difficult to dismiss as being temporary noise.

The euro may be a lesser, although still relevant, further factor to watch (Figure 2). Any renewed depreciation of the single currency would add to imported inflation, especially inside an ecosystem of already elevated energy prices. Any sustained period of weakening in the euro could therefore strengthen a case for added tightening.

Figure 2. The euro has traded inside a tight range recently

Daily nominal effective exchange rate of the euro, index level

The Risk Is for Overshooting the Inflation Target

The medium-term risk for the ECB is now clearly an overshooting of its inflation target rather than an undershooting.

That does not mean further tightening beyond today is inevitable. The underlying inflation picture remains sufficiently moderate for policymakers to pause and assess the damage. Nor does it mean today’s energy-price shock is inevitably about to produce a 1970s-style wage-price spiral.

But the margin for complacency has narrowed considerably.

The ECB’s decisions at October and December meetings will hinge less on where oil and gas prices stand on any given day than on whether elevated prices more materially alter wage negotiations, corporate pricing behaviour and household inflation expectations. Remember, traders are already pricing nearly three further 25bp hikes beyond today by the end of next year.

That makes the forthcoming weeks crucial. If energy markets settle, the ECB can afford to wait. If they stay under pressure, the balance of risks changes rapidly.

For the moment, 25 basis points today appears like a prudent next step.

Dennis Y. Shen is a macroeconomist and the former Chair of the Macroeconomic Council of the European credit rating agency. He is a lecturer at the International School of Management (Germany) and serves as a Member of the Supervisory Board of Visioneers gGmbH. He is a regular contributor for the London School of Economics.