ECB holds rates at 2.25% but signals September hike as oil hits $100 on Iran war escalation

Decision and rates

The European Central Bank left its benchmark deposit rate unchanged at 2.25% on Thursday, pausing after June's first hike in nearly three years. The decision was unanimous, but ECB President Christine Lagarde revealed that some Governing Council members had already questioned whether a rate increase should be considered at this meeting. The rates at which banks can borrow from the ECB for a day and a week remain at 2.65% and 2.40%, respectively.

Oil shock and inflation

The hold comes as Brent crude oil touched $100 a barrel for the first time in nearly two months, rising for a fifth consecutive day. Yemen's Houthis said they struck two Saudi oil tankers, widening disruption to global oil shipping through the Red Sea and the Strait of Hormuz as the conflict between the United States and Iran escalates. The ECB said it was "closely monitoring the intensity and duration of the shock, as well as its indirect and second-round effects," and warned that "the full inflationary impact of the energy shock has yet to play out." Natural gas prices are at their highest in more than three years, adding to cost pressures. Euro area inflation eased to 2.8% in June from 3.2% in May, while Germany's rate fell to 2.3% thanks to a fuel discount, but both remain above the ECB's 2% target.

Market reaction

Financial markets are pricing a 95% chance of a 25 basis-point rate increase at the ECB's next meeting on September 9-10, with a similar probability of another move by December. Germany's 10-year bond yield, the euro area benchmark, rose 3 basis points to 3.20%, holding at a 15-year high. The two-year yield, sensitive to rate expectations, climbed to 2.88%, near a two-year high. The euro dropped 0.4% to $1.1364, its lowest since July 1, while the pan-European STOXX 600 index fell 1.1%.

The fact that the market is pricing fully a rate hike for September is warranted by what we see on the energy prices. And we would really need a steep fall in the oil price for them not to deliver it.

Lagarde's commitment

Lagarde also addressed speculation about her future, stating she would serve her full term until October 2027. Earlier this month she had not ruled out an early departure to weigh in on French politics, but on Thursday she was emphatic.

When there are clouds on the horizon, the captain stays on the ship, and this captain is staying on this ship. You are not going to see the back of me before 2027.

What comes next

Analysts see the September meeting as live, with the bar to hold rates edging higher. Madison Faller of JPMorgan Private Bank said policymakers would need to see energy prices roll over quickly and little sign of spillover into the broader economy, conditions that look increasingly difficult to meet. Conor Parle of Fidelity International noted that gas prices were already rising before the latest Middle East tensions, driven by demand to refill low supplies ahead of winter and higher Chinese imports. Friedrich Heinemann of ZEW called the pause appropriate given the unpredictable situation in the Iran war, but said the ECB will be better placed to judge after the summer break when new inflation and growth data arrive.