The European Central Bank is almost certain to "stay put" tonight. However, the shadow of a rebound in inflation may force decision-makers to leave room for a rate hike in September. Against the backdrop of slowing wage growth and a weak economy, Lagarde faces a difficult game.

Source: Jin Ten Data

At 8:15 PM Beijing time on Thursday, the European Central Bank will announce its interest rate decision, with the market widely expecting the central bank to keep rates unchanged while leaving ample room for a rate hike in September, as conflicts in the Middle East have pushed oil prices back above $90 per barrel, and energy prices are putting new upward pressure on inflation in the eurozone.

Impacted by energy shocks, the European Central Bank raised rates by 25 basis points in June and hinted at further tightening of policies. However, the price, wage, economic activity, and inflation expectation data released in the following weeks have been relatively mild, reducing the necessity for further action by the European Central Bank.

Oliver Rakau from Oxford Economics stated, "We believe the European Central Bank will enter a 'hawkish pause' state." He mentioned that the latest data can barely support any further tightening of policies in the future.

"Current data will barely support further tightening of policies in the future, consistent with the June forecast and largely confirming the pricing in the market," Rakau said.

The financial markets currently expect that the European Central Bank will raise rates another two to three times, with the market fully pricing in a hike by the end of September and another by the end of April next year. Among these, the changes in oil prices play a greater role in this market pricing than the economic fundamentals. Bank of America predicts a 25 basis point rate hike in September due to the rebound in energy prices.

However, most economists believe that the eurozone, composed of 21 countries, does not need such extensive tightening to control inflation. A team of analysts at Bank of America noted in a recent report that they have not seen any signs of a tightening of policies recently.

They stated, "We firmly believe that regardless of whether the European Central Bank raises rates once or twice this year, the policy rate will peak at only 2% by the end of 2027. Why? We still believe the duration of inflation is much lower than expected. The scale of the current energy price shock is vastly different from that in 2022."

Jens Eisenschmidt from Morgan Stanley also stated, "Even with current oil prices, inflation is likely to reach target levels next year and be moderately below the target later this year. If you believe that forecast, then there is no reason to raise rates more than twice."

He added, "At a level of 2.5%, deposit rates will have a mildly restrictive effect, so if you are approaching the target, it will be quite easy to justify a decrease from that level."

Wages and service prices have not formed a second-round effect

Half an hour after the interest rate decision is announced, at 8:45 PM Beijing time on Thursday, Lagarde will hold a press conference. At that time, she may need to find a balance between inflation risks and mild data: indicating that decision-makers are still concerned about price pressures, further tightening is still on the agenda, while avoiding reinforcing interest rate hike expectations that have been largely digested by the market.

The European Central Bank can afford to be patient for a time, a key reason being that the "second-round effects" triggered by rising energy prices have not yet appeared. Rising energy costs typically push up the prices of goods and services and prompt workers to demand higher wages.

If wages and prices push each other, it could form a wage-price spiral. Current wage and labor market data have not shown this process.

Wage growth in the eurozone continues to slow, and the labor market is relatively weak, with the situation particularly evident in the largest economy, Germany. Firms surveyed by the European Central Bank also expect wage pressures to further diminish.

Consumers have lowered their price expectations, and detailed data show little evidence of a "second-round effect." The eurozone's annual inflation rate in June was 2.8%, down from 3.2% in May, and also below the previous expectation of 3%. Citigroup predicts that the eurozone's purchasing managers' index (PMI) will show "moderate growth" in July. Due to rising fuel prices, Citigroup expects that the growth of the consumer confidence index may stagnate in that month.

Trade tensions, high energy costs, and other factors will continue to suppress the eurozone's industry, and the region's industrial sector may face ongoing difficulties in the coming years, putting downward pressure on labor demand.

High temperatures and food prices constitute new inflation risks

European Central Bank decision-makers still believe that even if the scale of second-round effects is small and occurs later, the related pressures may ultimately arrive. Therefore, the central bank needs to retain the capability to take action again.

This month, much of Europe has experienced a scorching summer, and crops may already have been damaged, posing a risk of rising food prices. Key river levels are low, which may also lead to shipping bottlenecks.

Food inflation has generally declined in recent months, with weaker prices for commodities like sugar, cocoa, and coffee being significant reasons. Abnormally high temperatures and the El Niño phenomenon could change this trend.

Barclays stated in its report, "Although food inflation has generally been decreasing in recent months, reflecting softer prices for commodities like sugar, cocoa, and coffee, the unusually warm summer in Europe, along with the influence of the El Niño phenomenon, may put upward pressure on food prices again."

If the energy shocks spread to other goods, services, and wages, the European Central Bank may take action again in the fall. The focus of Thursday's meeting will be to maintain stable interest rates while making it clear that a rate hike in September remains a policy option.