Another hike ahead

Another hike ahead for the ECB, but then what?

The ECB is set to hike 25bp on Thursday, following June’s move with another as higher energy prices complicate the inflation outlook. What comes after that is less clear, with markets pricing further tightening that is not supported by unfolding domestic data. That leaves September looking more like another “insurance hike” than the resumption of a tightening cycle, and Lagarde with a difficult message to deliver.

At July’s meeting, Lagarde laid out a “laundry list” of indicators that would decide the path for rates¹. On those alone, further tightening isn’t supported by the data, as PMI price indices, negotiated wage growth and survey-based inflation expectations all point to easing underlying price pressures.

Shorter-term measures show services prices losing momentum too. That’s important when services inflation has been one of the ECB’s biggest concerns this cycle. All in, two-thirds of the way through the quarter, headline HICP is tracking around 3.2% for Q3 against the ECB’s own June projection of 3.4%. Core sits close to 2.4% versus 2.5% projected².

It’s true that the energy backdrop has clearly deteriorated since those forecasts were published. European gas now sits well above the EUR45.6/MWh that the ECB assumed in June, and stalled US-Iran talks raise the risk that pressure persists rather than fades. This will lift the near-term inflation profile in this week’s projections and give policymakers reason to emphasize the risk of an energy spillover into broader prices.

Bar for 2026 hikes beyond September remains high

But elevated energy prices are also a tax on household purchasing power and will weigh on demand. Without a meaningful second-round effect through wages and inflation expectations, that should limit how persistent the inflation impact becomes.

A hike this week therefore looks more like insurance against second-round effects than the start of a renewed hiking cycle. It also pushes the deposit rate toward the upper end of the ECB’s neutral estimates, with June’s move still working its way through the economy.

The rise in yields further raises the bar for another hike. Financial conditions have already tightened as the global bond selloff pushed borrowing costs higher across the curve. If that persists, some of the restraint the ECB is seeking will come through markets themselves.

For the ECB to hike again later this year, as markets are largely pricing for December, there would need to be renewed wage pressure or clearer evidence that higher energy costs are feeding into underlying inflation and medium-term inflation expectations. In the absence of that development, particularly if some of the external inflationary pressures fade from geopolitics to El Nino food effects, the case for another hike weakens.

For the euro, that would leave growth prospects and USD developments doing more of the work, tilting risks to the upside. We would also expect renewed curve steepening, particularly given the excessive flatness of the bund curve.

Growth prospects leave hikes on the table for 2027

While risks from the energy crisis remain, ongoing fiscal and investment impulses, largely funded from the EU and Germany, appear sufficient to drive a further growth recovery next year. That could prompt another rate hike into restrictive territory in late 2027, but clear signs of the economy running hot would be a prerequisite. In the meantime, growth resilience continues to underpin a constructive outlook for periphery debt.

Even as EU funds roll off, a fiscal impulse will still be evident from a lagged investment effect and SAFE funds coming through. As a result, we see the 10y BTP-bund spread retesting June lows over the coming months, and see the most attractive risk-reward profile barbelling between the 5y tenor and the longer-end of the Italian curve.

Bottom line

It all leaves Lagarde a narrow line to walk. She’s already declared forward guidance dead, but that makes the reaction function more, not less, important. Retaining the option to hike makes sense given how much uncertainty remains around the energy outlook. Signalling that another move is likely is much harder to square with what the domestic data are showing.

She’ll keep the door open. But markets will be watching how she views that laundry list - and whether the energy shock has changed the inflation outlook enough to warrant a renewed hiking cycle, or whether September proves to be a rinse and repeat of June.

With assistance from Asbjorn Friederich, senior sovereign analyst