At its policy meeting on 11 June, the ECB raised its deposit rate by 25 basis points to 2.25%. This automatically raises the refinancing rate to 2.40% and the marginal lending rate to 2.65%. This decision was unanimous, based entirely on the forecasts of the Eurosystem’s economists and advocated by ECB Chief Economist Lane. The decision was also in line with recent communications from ECB policymakers, including Executive Board member Schnabel, and with the latest market expectations. As a result, the market reaction to the German ten-year government bond yield was relatively muted. If there was any movement at all, it was a slight decline to around 3.03% by the end of the press conference.
‘Well-positioned’ once again
ECB President Lagarde also indicated that, following the rate hike to 2.25%, the ECB now considers itself well positioned once again to respond to further developments. The meeting did not discuss the ECB’s stance relative to the neutral rate. Lagarde even described the concept of the neutral rate as an equilibrium rate as somewhat irrelevant at present, given the major shocks currently affecting the eurozone economy.
During the press conference, ECB President Lagarde justified the interest rate decision primarily by citing the impact of the war in the Middle East on the eurozone’s medium-term inflation outlook. In the baseline scenario, Eurosystem economists raised their inflation forecasts for 2026 and 2027 to 3% and 2.3% respectively, with a slight reduction to 2% in 2028. The inflation path for underlying core inflation (excluding energy and food) was also revised upwards to 2.5%, 2.5% and 2.2% in 2026, 2027 and 2028 respectively. Inflation risks remain on the upside. The higher expected inflation path is the result of pass-through effects from higher energy prices to food, goods and services prices. According to the ECB, there is as yet no evidence of explicit so-called ‘second-round effects’, whereby inflation expectations begin to impact wage formation, for example.
At the same time, growth forecasts were lowered (by 0.1 percentage points across the board) to 0.8%, 1.2% and 1.5% in 2026, 2027 and 2028 respectively. The risks are tilted to the downside. The negative impact on expected growth is mainly driven by the pass-through of higher commodity prices to real incomes and the deterioration in confidence indicators.
Scenario analysis
To examine the robustness of these conclusions, the Eurosystem economists not only produced new projections for the baseline scenario, but also updated the ‘adverse’ and ‘severe’ scenarios from March. In addition, a new ‘milder’ scenario was introduced, which assumes a more favourable outcome than the baseline scenario regarding geopolitical developments and, consequently, future energy prices. In all four scenarios, the ECB concludes that today’s interest rate hike was the correct policy decision. The fact that a milder alternative scenario is also included, for which that policy conclusion also applies, made the decision robust, hence more than an insurance hike, and therefore inevitable, according to the ECB.
Does the ECB validate market expectations?
A relevant point to note here is that for the simulations in all four scenarios, so-called ‘technical’ assumptions are made for certain market variables, based on market expectations with 21 May as the cut-off date. Specifically, this means that the assumption for the money market rate is a three-month Euribor rate of 2.4% in 2026, 2.8% in 2027 and 2.7% in 2028. A key question for assessing future ECB policy is therefore to what extent the results of the ECB’s simulations (a return of inflation to the 2% target in the autumn of 2027) implicitly validate these market expectations. Plausibly, the simulation results do provide some insight into how the ECB might currently be thinking. However, what it will decide at its next policy meetings remains highly data-dependent. In any case, the ECB does not wish to commit to a specific interest rate path.
No ‘second-round effects’ visible yet
According to the ECB, the full impact of the war in the Middle East depends on the scale and duration of the energy price shock. In addition, spillover effects to other product categories also play a role (which are becoming increasingly visible) and, finally, the extent of possible ‘second-round effects’. According to the ECB, there is as yet no sign of this latter effect, although the risk related to it will be monitored closely. Lagarde noted that, based on market and survey data, medium-term inflation expectations remain fairly well anchored around the 2% inflation target (this is not the case for the short term). Nor does the ECB’s ‘wage tracker’, which monitors wage agreements in the eurozone, yet provide any indications that inflation expectations are having a stronger impact on wage agreements.
According to the ECB’s new projections, inflation in the eurozone will therefore remain above the 2% target until the first half of 2027 as a result of high energy prices and their pass-through to goods and services prices. In the autumn of 2027, inflation will then, still according to the ECB, fall back to around that target as a result of falling energy prices and slowing inflation in other product categories.
More than a precautionary measure, but no signal for a start of a tightening cycle
As mentioned above, Lagarde emphasised that the interest rate hike was necessary in all four scenarios considered and was therefore not merely an ‘insurance hike’, but rather an act of appropriate monetary policy. When asked whether this marked the start of a tightening cycle, she was only willing to reveal the following. Much will depend on how medium-term inflation expectations develop. In this context, she referred to the analytical framework she had proposed in March. In it, she stated that the ECB could look through a limited (and temporary) shock, respond to a larger shock that is not persistent with a well-calibrated policy adjustment, and respond forcefully to a significant and sustained deviation from the inflation target.
The first scenario is no longer relevant following the interest rate hike. On the other hand, according to Lagarde, a 25-basis-point rate hike is not really a ‘forceful’, but nevertheless an appropriate policy response. In light of the upcoming policy meetings, this suggests that, until further notice, the ECB is thinking in terms of a rather limited adjustment of its policy stance (well-calibrated) and does not wish to rush into anything for the time being.
