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

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.

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.

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.

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.