ECB Review: A “No-Brainer” Hike and More to Follow

• The ECB hiked policy rates by 25bp at the September meeting, with the deposit rate at 2.50%, in line with consensus and market pricing.
• The communication at the meeting, including the new projections, came as a very hawkish surprise to markets.
• The ECB revealed a firm focus on energy prices in its reaction function, so we now expect the ECB to hike in both October and December.

The ECB decided to hike its three key policy rates by 25bp at the September meeting, as expected, with the deposit rate at 2.50%. The ECB stated that “inflation is set to remain well above target for an extended period” in the press release, which was a clear hawkish surprise. Lagarde characterised the decision as a unanimous “no-brainer”, leaving the door wide open for further hikes. European rates rose across the board, led by the front end, with 2Y EUR swap rates rising around 15bp leading to a significant flattening of the curve. Markets price a total of 88bp worth of additional tightening with the peak reached in September 2027.

During the press conference Lagarde emphasised the surprisingly resilience of the economy. This has been due to new sources of growth such as global AI demand but also broad-based strength in Q2 which is expected to continue in the near term. On inflation, Lagarde mainly focused on energy prices and gave very few comments on developments in underlying inflation and wages. We see the benign developments of underlying inflation and wages as a dovish argument for the ECB, but the lack of focus on this in the ECB’s reaction function has been surprising to us. As the ECB reacts more to energy developments than underlying inflation compared to our previous expectations of their reaction function, we revise up our policy rate forecast.

The staff projections delivered a hawkish surprise with all forecasts either kept the same or revised up (see chart). However, the baseline forecast is already outdated as energy costs have moved up since the cut-off date of August 19. Hence, the adverse scenario is the one that best reflects the current energy market as oil prices are assumed at USD 100 per barrel and gas prices to EUR 75 per MWh in the fourth quarter of 2026. This scenario sees inflation at 3.2% y/y in 2027 and 2.3% y/y in 2028 with core at 2.8% y/y and 2.4% y/y, respectively. Growth is still expected above 1% in both years even with an assumption of a little more than one extra hike by the ECB this year. These projections support the ECB delivering at least one additional hike as that is already assumed in the projections.

New Call: 25bp Hike in October and December Before Cutting in H2 2027

We revise our forecast and now expect the ECB to hike policy rates by 25bp at the meeting in October and again by 25bp in December, bringing the deposit rate to 3.00%. The significant focus on energy prices in their reaction function means that we do not see why the ECB should wait for December before delivering the next hike. The risk to the call of an October hike is that energy prices drop significantly before the October meeting and that the ECB previously has used the meetings with new staff projections to hike. In that case, we would assume that the ECB only hikes in December. We deem hikes beyond December as more unlikely as we expect underlying inflationary pressures to only increase modestly.

With our expectations of a total of 100bp worth of hikes in 2026 we believe the negative growth effect and the curbing of inflation spreading outside of energy means that the ECB will start cutting policy rates in the second half of 2027. The timing of cuts is very uncertain and is highly dependent on the growth developments in 2027. We expect a first cut to come in the second half of the year with December being the most likely in our view. Hence, we forecast the ECB to cut the deposit rate back to 2.75% by 2027 year-end and then deliver further rate cuts in 2028.