ECB’s Next Move: Patience in July, Flexibility Later

The ECB’s Most Valuable Asset Is Flexibility

The European Central Bank is expected to leave rates unchanged at its meeting concluding today, choosing patience over prediction and preserving maximum room for manoeuvre ahead of a big decision by September.

Neither traders nor analysts believe the ECB will deliver a second consecutive hike today after last month’s increase. That means the deposit rate is seen remaining at 2.25%, a level officials have described as being “appropriate” as they evaluate implications of a re-escalation in the US-Iran conflict.

In an economists’ panel for Bloomberg I sat on, most economists left open the chance of a second quarter-point rise in rates by September, when policymakers will have new quarterly projections.

A ceasefire following the June ECB meeting along with weaker-than-anticipated inflation that month had bolstered hopes that the worst of the crisis may have passed. However – fresh hostilities recently, placing Brent oil back around USD 100 a barrel, have revived expectations for more tightening ahead.

Traders currently wager that an initial June move will be followed up by another in September and a final one by the end of this year. The ECB’s projections last month were based on assumptions for a total of three hikes this cycle.

Nevertheless, the message from Frankfurt today is unlikely to be a roadmap for the next move. Rather, it is likely to be a reminder that monetary policy remains highly dependent on developments that are unforeseeable. The ECB does not need to tell markets where it is heading when the destination still hinges heavily on an uncertain path of energy prices, exchange rates and geopolitical tensions.

At this stage, the Governing Council’s greatest asset is its flexibility – and it is unlikely to surrender that asset by prematurely signalling whether September may bring another rate increase or a prolonged pause.

Inflation Risks Had Recently Moderated

The ECB has already moved in response to the inflation shock of the recent months, and policymakers are likely to remain slightly cautious as concerns tightening further unless the data clearly demand it. The central bank’s challenge is not simply if inflation is elevated (Figure 1), but whether present pressures will prove persistent enough to prevent inflation from gradually returning nearer to its 2% target. Headline inflation slowed more than anticipated last month to 2.8% year on year.

Figure 1. Euro area inflation eased more than expected last month

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

The ECB is seen emphasising that it stands ready to act further while recognising that the broader inflation trend remains consistent with disinflation in the longer run.

Energy Prices Hold the Key in September

The inflation outlook has become a story of scenarios rather than certainty. Based on the four energy-price scenarios outlined by the ECB in June, the euro area remains currently nearest to the ECB’s baseline scenario.

The sharp decline in oil prices following an interim US-Iran peace agreement had shifted the balance of risks back towards near-term disinflation. Compared with the assumptions behind the ECB’s June projections, the fall in energy costs represented a meaningful downside risk (Figure 2).

Figure 2. Risks to euro area inflation on the downside this year

Nonetheless, the energy shock has not disappeared; it has simply become more conditional. Fresh geopolitical uncertainty has placed upside risks back on the inflation outlook and ensured that a September rate increase remains a genuine possibility.

The euro adds further complexity. A weaker currency (Figure 3) modestly worsens the inflation outlook by making imported goods, energy and commodities more expensive when priced in euro terms. Although the exchange-rate channel is unlikely to be the dominant driver of ECB policy, any sustained euro weakness may complicate central bank efforts at bringing inflation back to target.

Figure 3. The euro has weakened

Daily nominal effective exchange rate of the euro, index level

The decisive question today is how long-lasting renewed US-Iran tensions may prove to be.

If the recent escalation reverses and energy prices moderate, inflation risks may be tilted to the downside compared with ECB June forecasting. Under that scenario, the ECB may be able to hold rates unchanged for the remainder of this year.

But if a fragile ceasefire fails to return and energy prices stay elevated or further rise, the situation changes. A sustained oil shock, compounded further by a weaker euro, would raise the risk of second-round inflationary effects – especially if businesses and households further adjust expectations for future prices. Modest further signs that inflation expectations could become less firmly anchored would be adequate to convince the ECB to act.

Why Washington Matters for Frankfurt

So, the ECB’s September decision hinges as much on geopolitics as on the economic data. Here, the US administration itself faces meaningful pressure to prevent further escalation with Iran, not only because of the geopolitical consequences but also because of the economic fallout from another energy shock.

The renewed rise in energy prices adds pressure on the Federal Reserve to respond with tighter monetary policy. That dynamic creates an incentive for Washington ahead of elections to keep tensions contained. A prolonged confrontation would risk transmitting higher energy costs into both US and European inflation – forcing central banks into a more difficult policy trade-off.

For the ECB, the forthcoming months will be defined by uncertainty management rather than by a predetermined path. The central bank is unlikely to commit itself today because the economic destination is unclear. Its preferred strategy ought to be to preserve optionality and allow incoming information to shape its decisions.

The Question of Lagarde’s Exit

A further question looming over the ECB today is if its President, Christine Lagarde, may depart from her post before a formal expiry next October. Such a step would afford French President Emmanuel Macron a say in appointing her successor ahead of French presidential elections next spring. More recently, Lagarde announced plans of involving herself in France’s campaign, to elevate European interests “in whichever capacity I will be most efficient,” while saying she would not herself seek office.

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.