Europe | The ECB toughens its tone

After the 25-basis-point hike in June, bringing the benchmark monetary policy rate up to 2.25%, a pause was priced in for the European Central Bank’s (ECB) July 23 meeting. Attention focused on the clues the institution might provide regarding upcoming meetings, given the difficult international environment following the collapse of the preliminary agreement between the United States and Iran regarding the Persian Gulf crisis.

The clues provided by President Christine Lagarde during the press conference indicated an overall relatively hawkish tone, and the session proved to be more informative than the central bank's usual "pause" meetings.

First, she noted that some members of the Governing Council expressed a preference to raise rates at this very meeting. Although the decision not to do so was unanimous (as has usually been the case recently), this detail is in itself indicative that the balance is tipping in that direction.

Second, the balance of risks to inflation remains tilted to the upside. This does not represent a change from the June meeting, but it is a shift from the ECB’s annual forum in Sintra at the end of June—which brings together a large group of representatives from academia, the private sector, and central banks—where Lagarde spoke of more balanced risks. All of this coincided with a few weeks in which the truce in Iran was holding and oil prices had corrected sharply downward (to nearly $70 per barrel of Brent). Now, the geopolitical landscape is different, and the price has rebounded to $100 a barrel.

Third, the ECB remains highly concerned. We are still immersed in an environment of elevated uncertainty. The situation in the Middle East may be brought back under control, but new threats could also emerge. The latest episode is the threatened closure of the Red Sea strait, which has acted in recent months as a buffer for oil prices by allowing Saudi Arabia to export a significant portion of its crude production. Lagarde noted that they did not have enough time to incorporate this into their deliberations, but she described the threat as alarming. Thus, in this environment, the ECB will remain anchored in scenario planning (regarding oil and gas prices) to drive its decision-making. If the situation remains the same after the summer break, the probability of a benign scenario will decrease, and the likelihood of more negative alternative scenarios will rise.

Fourth, and although not novel, Lagarde was very clear in highlighting that the markets had a good understanding of the central bank's reaction function. Therefore, while not explicitly stated, she essentially validated market expectations, which are currently pricing in at least one more rate hike as early as September. Saying this when there are no intervening meetings indicates that they are comfortable with these expectations.

Fifth, however, a few hints were also dropped that suggest staying calm. The situation is highly volatile, and while it is prone to worsen, it can equally improve, and very quickly. The fact that the attacks are not affecting key infrastructure, for now, demonstrates that the incentives for both sides to continue negotiating are still there. The escalation in oil prices alone, along with the consistent rise in long-term interest rates (a relevant benchmark for the American economy), could act as a catalyst to return to the negotiating table.

Last but not least, anticipating the ECB's reaction beyond September relies heavily on what happens with second-round effects (i.e., the pass-through of energy price hikes into inflation expectations and, above all, into wages). For the time being, there is no sign of these effects in the Eurozone. Lagarde conveniently stressed this point more than once during the press conference.

In short, the picture remains open for September. Obviously, if the Strait of Hormuz is still closed by then, it will be very difficult for the ECB not to raise rates again. If, as we expect, the geopolitical environment stabilizes, the decision will depend on how the data evolves and the state of market confidence at that time.