July ECB meeting: A "no surprise” hike and a nuanced language shift

Today, the European Central Bank (ECB) raised its three key policy rates for the ninth consecutive time, opting again to raise rates by 25 basis points (bps). The interest rate on the main refinancing operations, the marginal lending facility, and the deposit facility will be increased to 4.25%, 4.50%, and 3.75%, respectively.

With 425 bps of rate hikes since last July’s lift-off, the ECB’s goal remains to dampen demand, tighten financial conditions, and guard against the risk of a persistent upward shift in inflation expectations. While progress on inflation continues, it is still expected to remain too high for too long, suggesting restrictive conditions will be required for some time.

Today’s rate hike decision came as no surprise—markets had priced in a 97% probability of a 25 bps hike. The policy statement did alter its language ever so slightly by changing from June’s “rates will be brought to levels sufficiently restrictive” to today’s “rates will be set at sufficiently restrictive levels.” This shift in emphasis from rate changes to rate levels may suggest the ECB believes rates are now sufficiently restrictive and therefore opens the door, albeit only slightly, to a future pause. The shift also appears to acknowledge recent economic weakness, as well as the ECB’s latest quarterly bank lending survey, which showed that business demand for enterprise loans has fallen to its lowest level on record, surpassing measures during the Global Financial Crisis. Markets interpreted the slight change in language dovishly, as reflected by the slightly weaker Euro and a minor rally in short-end euro-area bonds.

The ECB also confirmed that balance sheet normalization (known as Quantitative Tightening, or QT) is continuing “at a measured and predictable pace.” The asset purchase programme (APP) portfolio has been declining since the end of June, and the ECB confirmed its discontinuation of reinvestments under the APP. There was no change to the expectation for the reinvestment of PEPP principal payments until at least the end of 2024.

Inflation progress in headline but stubborn core

Headline inflation has steadily declined since its October 2022 peak, and June’s reported headline inflation figure showed a continued decline to 5.5%. By contrast, core inflation, the ECB’s preferred inflation measure (Core MUICP), showed a modest increase in June and, at 5.5%, remains well above the ECB target level of 2%.

The drivers of inflation are changing. External sources of inflation are easing, with energy price declines reflected in the progress in headline inflation. By contrast, domestic price pressures, from rising wages and still robust profit margins, are becoming an increasingly important driver of inflation and will likely continue to concern the ECB for an extended period.

Euro-area inflation
Year-over-year change, 2020–present

Euro-area business loan demand
ECB survey, loan demand by enterprises, 2003–present

Outlook uncertainty

Economic uncertainty remains elevated for the region, and policymakers must surmount a complex balancing act between weaker growth, elevated inflation, policy transmission risks and external international shocks. Today’s policy statement and press conference Q&A continually emphasized data dependence and offered little guidance on potential future ECB policy decisions.

Ultimately, the ECB (as well as markets) will be watching to see if the current economic slowdown continues and if further progress on inflation ensues. The ECB will likely opt to pause its hiking cycle once these developments become more visible and persistent. Nevertheless, the outlook for future policy decisions in the euro-area will continue to be driven by data-dependency and bounded by uncertainty, for the foreseeable future.