The ECB's measure approach to rates policy remains appropriate

The European Central Bank (ECB) kept policy rates steady at its October meeting, as expected. Rates on the deposit facility, main refinancing operations, and the marginal lending facility remained at 2.50%, 2.65%, and 2.90%, respectively. Overshadowing today’s policy decision, however, was ECB President Christine Lagarde’s announcement to step down early in February 2027.

While a rate hike was discussed at today’s meeting, President Lagarde noted that a measured approach remains appropriate given the risks on the horizon. Overall, her comments were consistent with a modest tightening cycle, with higher policy rates used to manage upside inflation risks amid the ongoing energy shock. We expect the next rate hike to come in December of this year.

Recent developments

Growth: Incoming data continues to suggest resilient economic activity, underpinned by strong AI-related investment and increased government spending on defense and infrastructure. Strengthening foreign demand should also continue to provide an additional boost to exports, helping support the growth momentum. Meanwhile, employment conditions remain balanced, with the labor market steady, yet far from overheating. Rising productivity is helping contain labor costs and keep overall wage growth in check.

Inflation: Though underlying inflation dynamics have remained broadly stable, the energy shock continues to exert cost pressures within supply chains, suggesting early stages of upward price pressures. Indeed, with energy prices trending above the ECB’s expected baseline path, Lagarde noted inflation is expected to stay above target in the quarters ahead. Risks also remain tilted to the upside, with supply constraints, a colder winter, or the effects of El Niño potentially amplifying second-round effects. However, inflation should eventually subside, in part, with the help of higher interest rates.

Financial conditions: Having tightened since the last meeting, financial conditions are helping to exert downward pressure on both growth and inflation. Market-based borrowing costs have also risen, a phenomenon that the ECB is closely monitoring. Amid questions about the increase in French government bond yields, Lagarde emphasized that the ECB has tools to address disorderly market movements that interfere with policy transmission, but that higher rates are a global issue that highly indebted countries must prepare for.

Leadership transition

Overshadowing today’s policy decision was an announcement earlier in the day that President Lagarde will step down from the ECB in February, rather than at the end of her term in October. Her successor will be appointed by the European Council, potentially by the end of the year.

There was much speculation leading up to the announcement, as it kicks off a leadership contest for her replacement. It also comes at an awkward time given the ongoing energy shock. Nevertheless, Lagarde pushed back against these concerns and affirmed the ECB’s governance and its ability to restore price stability.

Policy outlook

While the ECB debated whether a hike would be appropriate today, evidence of tighter financial conditions since their last meeting has given them additional time to assess how effectively policy is being transmitted across the economy. Indeed, they remain confident that the ECB is well positioned to wait for more data to signal whether potential second-round inflation effects are materializing.

Despite today’s decision to hold policy, President Lagarde was unambiguous that the bias for monetary policy will be further tightening until the inflation risk backdrop changes. We continue to expect another rate hike by December. Energy prices remain the principal vulnerability.