ECB Set for 'Insurance Hike' as Iran War Fans Euro Zone Inflation

FILE PHOTO: Dark clouds are seen over the building of the European Central Bank (ECB) in Frankfurt, Germany, June 6, 2024. REUTERS/Wolfgang Rattay/File Photo

The European Central Bank is all but certain to raise interest rates on Thursday in the hope of nipping higher inflation in the bud before a surge in energy costs triggered by the Iran war spreads more broadly across the euro zone economy.

The well-telegraphed move would come as inflation in the 21-country currency bloc is already above 3%, well in excess of the ECB's 2% target, and economic growth is very weak - a backdrop that has economists split over the case for tighter policy.

ECB policymakers, some of whom had already pushed for action in April, are nonetheless expected to press ahead, seeking to keep a lid on inflation expectations and to safeguard their credibility after being slow to react to a post-pandemic inflation spike in 2022.

"The ECB needs to hike ‌to protect credibility ‌and prevent inflation expectations from de-anchoring, but it is still operating around neutral rather ‌than ⁠moving decisively into restrictive ⁠territory," Annalisa Piazza at MFS Investment Management said.

Thursday's hike would be the first in nearly three years and take the ECB's benchmark deposit rate to 2.25% from 2.0%. Sources have told Reuters the ECB is unlikely to commit to further rate rises this week but financial markets expect another two over the coming year, with the next move seen as soon as September.

The bank's new economic projections are also likely to hint at further rate hikes.

"New staff projections are likely to be consistent with three hikes and (ECB President) Lagarde is unlikely to dismiss this as unreasonable," JPMorgan's Greg Fuzesi said. "That would give the meeting a ⁠clear hawkish feel, even if the communication is likely to be more consistent with ‌the next move in September."

AN 'INSURANCE HIKE' THAT UNDERPINS EXPECTATIONS

Several ECB watchers have ‌characterized the expected move as an "insurance hike" - a precautionary step that could be reversed if price pressures fade.

Supporting the case for action, ‌the ECB is likely to raise its quarterly inflation projections on Thursday, bringing them closer to its "adverse" scenario published ‌in March, which saw inflation peaking at 4.2% in the final quarter of this year before falling back sharply in 2027. Consumers, companies and financial investors have revised their own views about price hikes, although medium-term expectations remain close to the ECB target and far from their levels in the aftermath of Russia's invasion of Ukraine.

"Two hikes this year thus looks like a minimum," Anatoli Annenkov at Societe ‌Generale said. "Markets are likely to start pricing in the next hike in July... but we still think a majority of governors would prefer to wait for more ⁠data and new forecasts in September."

HEADING ⁠FOR A POLICY MISTAKE?

Not all economists are convinced. Some warn the ECB risks tightening into an economy that is already paying a high price for the Iran war.

Berenberg's Holger Schmieding said the ECB was "heading for a policy mistake" given a stagnant labor market and weak consumer demand.

"Amid the ongoing destruction of demand, the inevitable temporary surge in prices ... seems unlikely to turn into a protracted inflation problem that would need to be addressed by higher rates," he wrote in a note. A Reuters analysis of earnings call transcripts by euro zone companies showed just 40% of those outside the financial sector had raised prices or were planning to do so, roughly half the share seen as the Ukraine war pushed up energy prices in 2022.

Eric Dor, director of economic studies at France's IESEG School of Management, said the ECB was overestimating its ability to influence household and business expectations, particularly in a situation where inflation is driven by fuel costs rather than domestic demand. But the ECB has sharpened its messaging in support of tighter policy. Chief Economist Philip Lane - typically seen as an inflation "dove" - has said the Iran-related shock may be broader in scope than the Ukraine crisis, as it affects global energy markets rather than primarily Europe.