The European Central Bank opted to keep borrowing costs on hold on Thursday, maintaining the deposit rate at 2.25%, but it made clear that additional rate increases remain possible if recent shocks to energy prices persist.
In its statement, the ECB said it was "closely monitoring the intensity and duration of the shock, as well as its indirect and second-round effects." The central bank’s language left policy optionality intact as geopolitical tensions in the Middle East drove energy prices higher.
Markets responded: the euro extended losses, trading down 0.2% at $1.1388, and interest-rate sensitive two-year bond yields across the euro area stayed elevated. German two-year yields were last seen up roughly 2 basis points at 2.86%. Money market pricing suggested a strong probability of two additional rate increases by the end of the year.
Market and analyst reactions
"After raising interest rates in June, as expected, the ECB is on hold today. The Governing Council’s focus remains on inflationary pressures, with the latest events in Middle East set to push up the ECB’s expectations of where inflation is heading later this year. And although no pre-commitment to future policy path is provided, the ECB will clearly have a bias toward tighter policy," said Marchel Alexandrovich, European economist at Saltmarsh Economics in London.
"Preserving optionality should not be confused with complacency. As one of the first movers earlier this year to hike amid inflation pressures, today’s meeting reinforces the same instinct: to stay in front of the risk, not behind it," said Madison Faller, global investment strategist at JP Morgan Private Bank in London.
Market commentary noted that the decision keeps the September meeting live as a potential point for further action, with the threshold for holding rates appearing to rise. Policymakers would likely want to see energy prices retreat and little evidence of spillovers into the broader economy before stepping back from a tightening bias - conditions the market sees as increasingly difficult to satisfy given the renewed focus on energy and inflation.
"The ECB left interest rates unchanged at their meeting today, but against the backdrop of higher commodity prices and the latest increased tensions in the Middle East, this pause is likely to be temporary," said Conor Parle, euro zone economist at Fidelity International in London.
Parle added that gas prices had been rising even before the latest tensions, driven by higher demand to refill low inventories ahead of winter and increased Chinese imports, both of which are likely to support further upward pressure on gas markets. He said that reasonable resilience in the euro area economy meant that, once the ECB updates its September forecasts, it would likely be positioned to raise rates by a further 25 basis points to the upper end of its neutral range while underscoring its commitment to price stability.
Ed Hutchings, head of developed market rates at Aviva Investors in London, warned: "Overall, the immediate priority for the ECB is clear: addressing the inflationary backdrop, and as such the market is right in thinking more hikes will be coming down the line, but with one hike already being delivered and more than two further hikes priced, have things gone too far? It’s certainly beginning to look that way."
The ECB’s decision and its forward guidance reverberated through markets sensitive to interest rates and energy costs, reflecting a balance between a pause in action now and the preservation of the option to tighten further if energy-driven inflation proves persistent.