The European Central Bank held its policy rate at 2% and signalled a cautious stance as officials weighed higher inflation against the risk to growth from rising energy costs tied to the Iran war. Policymakers debated raising rates at length but chose to leave borrowing costs unchanged, reflecting concern about the economic fallout from the conflict.
Following the decision, traders dialled back expectations that the ECB would deliver three 25 basis-point increases this year. Money markets now price roughly an 88% chance of a quarter-point hike in June, down from a position earlier in the session that effectively fully priced such a move. By year-end markets expect about 72 basis points of tightening, a level that suggests three 25-bp rises are no longer a certainty.
Two sources close to the ECB discussion later indicated to reporters that the bank is likely to raise interest rates at least twice this year, with the first move starting in June. That assessment aligns with several market participants who said the governing council wants to remain data dependent and keep options open until the next meeting to evaluate inflation developments.
Market reactions were immediate. Government bond yields across the euro area slipped after the hold, as traders pared back wagers on the extent of future tightening. Two-year German yields, which are particularly sensitive to expectations around ECB policy, fell 7 basis points to 2.65%.
A drop in oil prices from a recent four-year high contributed to the downward pressure on yields, along with data released earlier in the day showing the euro zone economy barely expanded in the first quarter. That weak growth print highlighted the vulnerability of Europe - a large importer of oil and gas - to surging energy costs and the difficult balancing act confronting the central bank.
Germany's IMK institute raised its estimate for the probability that the country's economy will enter recession in the second quarter to 34%, up from 12% in March, underlining an elevated risk to the bloc's largest economy if energy prices remain elevated.
Markets have been volatile as the conflict has altered the outlook quickly. Expectations swung sharply in recent weeks: two weeks earlier, oil prices had fallen after an April 8 ceasefire, prompting traders to scale back ECB rate-hike bets, only for those bets to firm again in the most recent week. On Thursday benchmark Brent crude briefly reached $126.41 a barrel, its highest level since 2022, before pulling back to around $114.
Investment professionals highlighted the difficulty for central banks in this environment. "Clearly they (ECB policymakers) want to keep their options open so that they can remain data dependent and have time until the next meeting to see how inflation develops," said Jill Hirzel, senior investment specialist at Insight Investment. She noted the ECB has an inflation mandate but also factors in the impact on growth, and she personally leans toward expecting two rate hikes this year.
Joost van Leenders, senior investment strategist at Van Lanschot Kempen, said the rapid shifts in market pricing make policy decisions tough and described the market-implied path of three hikes as "a bit aggressive."
The decisions by other central banks reflected similar caution. The Bank of England left its policy rate unchanged at 3.75% and saw British government yields decline amid signs of reluctance to tighten further. The U.S. Federal Reserve also held rates steady the prior day, contributing to a broader theme of central banks buying time to assess the conflict's trajectory and potential second-round effects on inflation.
Alessia Berardi, head of global macroeconomics at the Amundi Investment Institute, said central banks appear to be stepping back to gather information on how long the conflict might last and whether high oil prices will persist, as well as to monitor any knock-on impacts on inflation expectations and wages.
The euro initially dipped after the ECB decision but later strengthened to trade about 0.5% higher at $1.173. European equities rallied, extending gains and finishing the trading session up roughly 1.3%.
Pictet Asset Management's lead economist Nikolay Markov said his firm expects the ECB to deliver two rate increases this year. He cautioned that a prolonged closure of the Strait of Hormuz and a sustained rise in oil to $150 a barrel could push euro zone inflation to 6%, double the rate recorded in April.
With policymakers emphasizing data dependence and acknowledging the headwinds from energy prices, the market now appears to be pricing a more moderate tightening path for the ECB than the earlier expectation of three quarter-point hikes. The central bank faces the twin challenge of reining in inflation while not exacerbating a fragile growth backdrop that is sensitive to swings in energy costs.