Just two weeks after European Central Bank (ECB) President Christine Lagarde warned that the institution was heading toward a new interest rate hike, such a move in June looks less and less like a foregone conclusion. Cooling inflation dynamics, the lack of a strong second-round effect from rising energy costs, and the stalling eurozone economy are causing some central bankers to step back from their initially hawkish tone.
From "we know where we're going" to "we shall see"
Until recently, the message from Frankfurt was that tighter monetary policy was practically inevitable unless price pressures clearly eased and the war in the Middle East ended.
Now the emphasis is shifting: ECB officials are increasingly openly saying that further evidence of deteriorating inflation prospects will be needed before proceeding with another rate hike as early as June.
This is a step back from Lagarde's unusually direct statement after the last meeting, when she declared: "I generally know where we are going."
The reason for the change is the persistent geopolitical uncertainty surrounding Iran – a factor that is causing other major central banks to wait, in the hope that a potential de-escalation of the war might limit the need for painful interest rate spikes.
Signals from the data: inflation is more manageable, wages under control
Recent macroeconomic data bolster the argument that the higher borrowing costs already priced in by the markets are not an inevitable scenario.
Surveys and market expectations point to faster inflation in the short term, but medium- and long-term forecasts remain relatively stable.
Wage growth in the eurozone also seems tamed – increases are far below their previous peak levels and, for now, do not suggest a "wage-price" spiral.
Bank of Finland Governor Olli Rehn described inflation expectations as "still stable" and developments in wages as "reassuring."
Even Executive Board member Isabel Schnabel, considered one of the most "hawkish" voices at the ECB, pointed out that while the risk of tightening has increased, it would be necessary only "if the energy shock spreads" to a wider range of goods and services.
Economy on the edge: weak growth as an argument for waiting
The other key factor is the state of the economy. The eurozone barely saw growth in the first quarter, and subsequently, a decline was recorded in the services sector.
Further weakness in the real economy could offset some of the inflationary pressure and give the ECB an argument to refrain from further monetary tightening.
ECB Vice President Luis de Guindos, who retires this month, called for caution precisely because of the effect on growth, which he said "will become much more visible in the coming weeks."
Bank of Greece Governor Yannis Stournaras described recession fears as "real and justified" – a comment that is hard to ignore in the debate.
"We are already seeing some weakness in the economy," commented Anatoli Annenkov, senior economist at Societe Generale. "This will reduce inflationary pressure and the risk of secondary inflation effects. Tightening policy should not yet be taken as a settled issue," he adds.
Markets have already priced in hikes – "hawks" vs "doves"
Despite the more cautious tone from some central bankers, the expectation of further rate hikes prevails in the markets.
Traders are currently betting on three upward steps, starting from the June meeting.
Economists surveyed by international media are overwhelmingly forecasting 0.25 percentage point hikes in June and September.
These expectations are largely fueled by the firmer positions of the "hawks" at the ECB – such as German Governor Joachim Nagel, Austrian Martin Kocher, and his Slovak counterpart Peter Kažimír, who believe that a hike in June can only be avoided if there is a clearly positive development regarding the war and the energy market.
"Recent signals from the ECB suggest that a rate hike is either inevitable or the base case scenario in the absence of major surprises," commented Paul Hollingsworth, chief European economist at BNP Paribas Markets 360. "We might even see a discussion about a larger step if energy prices continue to rise significantly," he adds.
Lagarde's dilemma: better too early or too late?
The decision facing the ECB Governing Council is multifaceted: to demonstrate resolve with a rate hike as early as June and risk the need for a quick correction later, or to wait for more data and potentially be forced to "play catch-up" with more aggressive steps in the future.
Christine Lagarde clearly realizes that in the past, the ECB has made both types of errors – reacting either too early or too late.
"We are constantly torn between the risk of reacting too quickly and the risk of reacting too late," she says in an interview with Spanish television.
According to Katharina Utermöhl, lead economist for Europe at PGIM, "the situation in the Middle East is likely to remain highly uncertain for some time," so the ECB will seek to avoid making firm promises about the future course of policy.
Against this backdrop, the June meeting is shaping up to be a test of the balance between "hawks" and "doves" – and of the ECB's ability to maneuver between the pressure of markets, political expectations, and real economic data.