Markets are still favoring a pause and are pricing a European Central Bank rate hike this week at less than even odds.

But we are switching our expectations for the ECB interest rate decision this Thursday from a pause to a 25-basis points hike.

The more we re-run in our minds what we have heard from ECB officials, wargame their tactical choices, and analyze the data and risk management dynamics that will be debated at the Governing Council meetings tomorrow and Thursday, the less comfortable we are with our briefly held, and highly unusual for us dovish call that they will pause at this meeting.

And so even if it is almost at the last minute, we are unequivocally switching our expectations for the ECB on Thursday to a hike. As to messaging, that also comes back full circle to our long held expectation, and what we have more or less understood the ECB game plan to be, that after the Council at this meeting brings its benchmark deposit rate to 4% it will signal that future decisions will be guided from here on at a slower and more deliberate pace by the staff’s quarterly forecast assessments, as they were before the Covid era.

The discussion and decision from the two-day meeting will of course be far more nuanced than a simple “stop or go” debate. As one ECB official put to us before the blackout period:

[Thursday’s decision] is a relatively open call, we see both sides. Our measures are working, we know there is a delay [in the transmission of tight policy], and the main impact of the hikes is yet to come. But inflation is coming down a little slower, and energy prices may be more volatile than we would like.

Importantly, he added:

Our mandate, in contrast to the Fed’s mandate, plays a role. Our goal is not a soft landing, as desirable as that may be, but price stability.

With growth slowing more than expected, a case can clearly be made for a “hawkish pause” as the prudent choice for the ECB at this juncture, as we laid out in our previous two reports. But there is an equal if not more powerful case that will be made by hawks that in the larger picture the prudent choice for the GC is to squeeze in another rate hike to ensure that rates are indeed at a “sufficiently restrictive” area to bring inflation down to the ECB’s 2% target within a two-year horizon.

We believe the latter is not only the right choice, but more importantly for our clients is the one that will prevail.

ECB officials have pointed to “date dependence,” and the quarterly forecast revisions that will be presented by Chief Economist Philip Lane as the driving force ultimately behind this week’s decision.

Yet by and large, most officials, and markets, have a good sense for how these forecasts will pan out, and the final decision will therefore, as we have written, not be driven by a decimal point here and there, but by broad, risk management considerations.

The forecasts, as characterized by ECB Vice President Luis de Guindos, are likely to show a lower growth trajectory than expected in June, and an inflation outlook that is “more or less” as expected in June.

Putting a finer point on that inflation outlook, analysts expect that is likely to translate into a slightly higher figure in the near term, and perhaps a small tweak lower to the 2.2% outlook for 2025 due to slower economic activity. But even a small revision to 2025 inflation, if it does show up in the numbers, will be insufficient progress for ECB hawks, and the leadership, to hang their collective hats on.

In her final speech before the black out period, ECB Executive Board Member Isabel Schnabel made the case that this week’s decision should not be made on the inflation forecast alone:

I will close my remarks by explaining why the current environment of high uncertainty warrants an approach to monetary policy that is data-dependent and robust, in the sense that it considers not only the most likely future path of inflation but the entire distribution of risks.

With downside growth risks rising, we took this as confirmation from perhaps the most influential hawk on the ECB of increasing sensitivity around the system to the shifting risk between over-tightening and under-tightening, and we continue to believe that to be the message.

But that does not mean those risks have flipped, or are even yet at neutral, and this is where tactical considerations come into play, and those, as we keep running it through our minds, point to one more hike now rather than later – possibly — after a “hawkish pause.”

The goal for the ECB at this juncture is to keep financial conditions tight enough to ensure that the 2% target is indeed met by 2025. The argument of the importance reaching and holding a sustainably (but not overly) high plateau has been made most notably and frequently by Banque de France Governor Francois Villeroy de Galhau. That is somewhat at odds with the more hawkish comments by his Austrian colleague Robert Holzmann who has been calling for one “if not more” hikes from here, as the ECB can always cut if it over-tightens.

There is of course an open debate as to what exactly that “sufficiently restrictive” level may be, given the data the ECB has and the forecasts it will have in hand. Yet at this point there is little drama, except from the truly most ardent of doves who have fought hikes through this entire cycle, over whether that might be 3.75% or 4%, a fine-tuning difference in the scheme of things. Which leads to the tactical considerations…

Over the past week or so, we have been asked repeatedly by clients whether the ECB, knowing that the year-on-year core inflation numbers are highly likely to come down in perhaps September, and almost surely in October, can “sell” a hawkish pause at 3.75%. The short answer is no, and that a pause will, in our minds, without a question lead to an easing of the effective financial conditions that, as Schnabel had also pointed out, have been drifting down already.

A corollary of that argument, which we have laid out in previous reports, is that hawks may feel that if they don’t get a hike now, it will be harder if not impossible for them to get one after the inflation numbers have come down. While this may be in many of their hearts, it is not a sound argument to make from a policy perspective. The real decision needs to and will be made over the appropriate monetary conditions that need to be set now.

On those monetary conditions, a comment that was made to us earlier by an ECB official now keeps ringing in our ears. That is that markets are already pricing in relatively high odds for another rate hike over the next few meetings, so why not just bring that all forward into a hike now?

And finally, as to defying market expectations of less than even odds of a hike priced in, well that, as suggested by this official, is where ECB President Christine Lagarde’s role, with the support of the Board, will now be to lead.

Sassan Ghahramani

President and CEO