Exploring the ECB’s Predicament: Rising Interest Rates and Potential Implications

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This week’s highly anticipated European Central Bank meeting is expected to generate intense debate. For more than a year, there has been a general consensus among eurozone monetary policymakers that interest rates need to rise in order to combat inflation. Since July 2022, rates have been increased by 4.25 percentage points. However, as signs of an imminent recession in the eurozone become more evident, and with yearly price growth now at half of its peak of 10.6 percent, unity over the direction to take is starting to fray.

The central bank’s governors are divided, with some favoring another 25 basis point rate increase, possibly the last one, while others are advocating for a pause. In addition, following a stream of weak economic data, a narrow majority of investors now predict that the ECB will refrain from making changes on Thursday. Even ECB watchers are divided.

During the summer, indicators of activity in the eurozone’s manufacturing and services sectors indicated an imminent economic slowdown. Lending has also been constrained by the current interest rates, which are at 3.75 percent. In fact, on Monday, the European Commission lowered its growth outlook for the eurozone for this year from 1.1 percent to 0.8 percent, with Germany, the largest economy in the region, experiencing a contraction.

The camp advocating for a pause argues that a slowdown in economic growth could bring down inflation without the need for further rate increases. They also believe that a higher cost of credit could lead to a deeper economic slowdown. A pause would allow the ECB to monitor developments, including the impact of previous rate hikes, until its next meeting in late October. While this argument seems plausible, investors may be underestimating the possibility that the central bank will ultimately raise rates at this meeting.

Firstly, core inflation, a measure of underlying price pressures, remains stubbornly high. Although it has eased, it stood at 5.3 percent last month, well above its historical average. With the labor market still tight, annual wage growth is contributing to price pressures, particularly in the services sector.

Secondly, while economic growth has weakened more than expected, there have also been a few factors that pose upside risks to inflation. Oil prices have risen, and Europe’s reliance on liquefied natural gas exposes it to global supply shocks, including recent strike action in Australian plants. Alongside elevated core price growth, these shocks could keep inflation, as well as medium-term inflation expectations, which increased in July, higher for a longer period.

Thirdly, after falling behind on inflation, the ECB has expressed a preference for a hawkish stance. The central bank has chosen to err on the side of doing too much rather than too little in the fight against inflation. In the past, the ECB has gone against market expectations, and it may feel the need to do so again on Thursday to emphasize its commitment to fighting inflation. After all, President Christine Lagarde highlighted the risks posed by structural shifts that could lead to persistent price pressures and uncertainty in her Jackson Hole speech last month, and warned that “the fight against inflation is not yet won.”

There is a possibility that the markets interpret a decision to pause as a signal that the hiking cycle is complete. Lagarde could attempt to convey a hawkish stance while pausing, creating room for a potential rate hike next month. However, this may be difficult to execute. If investors assume that rates have peaked, financial conditions could loosen.

There are potential pitfalls in either direction: keeping rates unchanged invites criticism that the ECB is giving up too early, but raising rates risks exacerbating an impending economic downturn. Regardless, Lagarde needs to firmly communicate the ECB’s commitment to meeting the inflation target and emphasize that rate cuts are not on the horizon. It is a difficult decision to make, but actions will speak louder than words in conveying this message.