The European Central Bank (ECB) is preparing to raise interest rates to their highest level in more than two decades, despite the eurozone slipping into a recession. Analysts predict a 0.25 percentage point increase, bringing the key deposit rate to 3.5 percent, a level last seen in 2001. Recent economic data suggests that the ECB’s aggressive tightening measures have been effective, and President Christine Lagarde’s press conference will focus on any indication of when rates might reach their peak. Market expectations anticipate another quarter-point hike in July.
Despite the ECB’s efforts, headline inflation remains significantly above the central bank’s target, with inflation projected to remain above target for four years before returning to below 2 percent. However, there are signs of improvement, as headline inflation has decreased from its peak of 10.6 percent in October to 6.1 percent in May. Core inflation, a more reliable indicator of underlying inflation trends, has also started to ease, and consumer inflation expectations have decreased.
Nevertheless, the eurozone’s economy appears weak, with official data indicating a recession over the winter and concerning manufacturing orders and bank lending data. While weak economic performance would typically keep prices in check, record-low unemployment has sustained domestic demand despite minimal growth. This, along with skepticism regarding the effectiveness of old economic models, raises doubts about whether the inflation challenge has been overcome.
The ECB remains vigilant due to wage dynamics, as employee compensation rose by 5.2 percent in the first quarter, and government energy subsidies continue to support disposable income. Lagarde is unlikely to provide clear guidance on when the ECB will cease raising rates, emphasizing the importance of incoming economic data.
The ECB’s communication may be influenced by potential changes to inflation forecasts for 2025. The end-of-horizon inflation forecast is used by the ECB to signal its policy bias, and as long as it remains above 2 percent, the bank maintains a tightening bias. It is anticipated that the ECB staff forecasts will be adjusted to exactly 2 percent in September, aligning with market expectations of one more rate hike in July before a pause.
