ECB makes a hawkish hold

As expected, the European Central Bank (ECB) kept policy rates unchanged today, following a hike at its last meeting. Rates on the deposit facility, main refinancing operations, and the marginal lending facility remained at 2.25%, 2.40%, and 2.65%, respectively.

In the face of elevated geopolitical uncertainty, ECB President Christine Lagarde characterized policy as being adequately positioned to wait for more data and a fresh set of forecasts before its next meeting. Yet her heightened concern around the renewed increase in energy prices and second-round inflation effects left enough room to signal likely additional tightening may be ahead.

Recent developments

Growth: Despite headwinds from the Middle East conflict, overall economic growth is expected to stay modest as activity in the second quarter remained resilient. It was bolstered by a rebound in the services sector, together with robust investment and manufacturing activity. Meanwhile, the outlook for the labor market remains weaker than before the conflict. Lagarde acknowledged that the fundamental drivers of growth, including solid private consumption, strong technology and digital investment, and increased public spending on defense and infrastructure, remain intact.

Inflation: Though inflation eased in June, the energy shock continues to feed into prices as higher input costs lead firms to raise prices. Moreover, Lagarde emphasized that the full effects of the energy shock have yet to fully play out, as the ECB expects inflation to remain above target through the first half of 2027. While developments in underlying inflation remain in check—longer-term inflation expectations are anchored, and wage growth is contained—second-round effects will need to be closely monitored given the ongoing nature of the conflict.

Risk scenarios: While the risks to the growth outlook are tilted to the downside, they are tilted to the upside for inflation. The longer energy prices remain elevated, the more likely they are to drive up broader inflationary pressures through second-round effects like higher wages. Lagarde noted that as the geopolitical situation remains fragile, the ECB’s mild scenario—one in which energy prices normalize rapidly—now looks quite unlikely. Instead, the current path is closely tracking the baseline scenario it presented back in June, which assumed three policy rate hikes in total.

Policy outlook

After sounding slightly more relaxed in early July as oil prices came down and inflation prints surprised to the downside, the recent escalation in geopolitical tensions means that the ECB’s stress levels have gone back up. Second-round inflation effects have yet to materialize, but they remain a key risk to the outlook.

Though Lagarde provided no explicit forward guidance, she dropped some hawkish hints, including saying that some in the ECB debated whether a hike was in fact needed at today’s meeting. Indeed, oil prices that are close to the June baseline, which assumed three rate increases, are a fairly strong indication that further tightening lies ahead. It is very likely that inflation increases are heading toward the continent and the European Central Bank will need to respond. We expect a September rate hike with a high likelihood for a further increase later in 2026.