ECB Policymakers Back Measured Rate Approach as Eurozone Inflation Climbs to 3.8%

Measured stance on energy shocks

Eurozone headline inflation rose to 3.8% in September from 3.2% in August, driven by an 18.8% year-on-year increase in energy prices. The 21-nation currency bloc experienced a renewed rise in oil and gas costs, compounded by expanding refinery margins after the conflict involving Iran began in February. Speaking at a monetary policy conference in Frankfurt, European Central Bank Chief Economist Philip Lane explained that policymakers are keeping a middle path to control price growth. The ECB previously raised its deposit facility rate from 2.0% to 2.5% across two policy steps in June and September. Lane noted that energy futures show oil and gas prices will decline less steeply through 2028 than previously anticipated, requiring central bank decisions to remain data-dependent.

In addition to tracking the ongoing transmission of the first wave, it is key to assess whether the second wave will have a stronger impact on both the level of activity and the inflation dynamics than the first wave.

Demand destruction and fiscal tightening

Higher energy costs and rising market borrowing costs are reducing household real incomes and corporate profits across the currency union. Lane pointed out that these demand destruction channels temper economic activity and limit the need for aggressive interest rate hikes. Broader macroeconomic conditions are also shifting, as fiscal stimulus is projected to turn into fiscal tightening of 0.4 percentage points in 2027 and 0.2 percentage points in 2028. While German defense spending and Next Generation EU infrastructure projects supported 2026 output, government consumption growth is projected to moderate. Lane added that corporate investment in artificial intelligence infrastructure has pushed up corporate borrowing without creating wage pressures in data center construction.

All else being equal, these 'demand destruction' channels can limit the required adjustment in the monetary stance to ensure the timely return of inflation to the target.

Second-round effects and market expectations

Speaking at a precious metals conference in Sorrento, Italy, Bundesbank President Joachim Nagel reported that energy costs have not yet altered wage and price setting. Nagel stated that long-term expert and market inflation expectations remain anchored around the 2.0% target. However, he warned of supply risks including depleted European gas storage, refining capacity constraints, and agricultural pressures from droughts and fertilizer shortages. Nagel noted that rising yields increase the appeal of bonds for reserve managers, while geopolitical stress supports gold diversification. Money markets currently price a 20% probability of an ECB rate hike in October and an 80% probability in December, repricing downward from four hikes priced a week earlier. The ECB projects inflation will remain above 2.0% until the first half of 2027.

There are so far no clear signs that inflation has fed through to price and wage setting.