"The justification for the decision lies principally in relation to concerns regarding the outlook for inflation across the single currency region. Last week’s HICP inflation data for August confirmed that higher energy prices are already feeding into higher headline inflation, the year-on-year increase from 2.9% in July to 3.3% last month, almost entirely down to energy.
"More specifically, the central bank will be concerned regarding the sharp increase in regional natural gas prices which are now significantly above the are now significantly above the E45/MWh level identified in its own pessimistic outlook scenario published back in June. Confirmation that the region’s gas storage level stands at just 65% against a 90% target by end-November and the onset of winter, points to a structural supply problem risking another sharp upward price spike not unlike that witnessed in the autumn of 2022.
"The Governing Council will not want a repeat of the 2022 regional gas supply shock which saw headline inflation rise in excess of 10% and the euro hit parity against the US dollar, thus a strong imperative exists for rate-setters to act pre-emptively even though underlying consumer price pressures appear subdued with few indications, as yet, that higher energy costs are being passed through.
"President Lagarde is likely to face questions in her ensuing press conference regarding how the Governing Council views the recent surge in regional government bond yields. In part, the bond market sell-off is being driven by international factors over which the ECB has no control, however, the adjustment is being driven, in further part, by rising fiscal concerns, notably in relation to France and Italy. Mme Lagarde is highly likely to emphasise that the adjustment is not (yet) as pronounced as during regional crises of the past and that its armoury has been subsequently strengthened, particularly through the as yet unused Transmission Protection Instrument (TPI).
"Nonetheless, senior ECB officials will not want to be criticised for “falling behind the curve”. The highly regarded Executive Board member Ms Isabel Schnabel put it well stating recently that, “It is critical to prevent the occurrence of second-round effects early on because acting late could necessitate more (policy) tightening (in the future”.
"Beyond the justifications lying behind this week’s likely rate hike, much will hinge on the ECB’s perception regarding the outlook and the evolution of price pressures in particular. Financial market futures anticipate two further 25-basis point rate hikes, taking the Discount Rate to 3.00% by spring 2027. Without delivering any specific guidance other than the reiterated commitment to be guided by incoming data and a preparedness to act as necessary, senior officials are unlikely to want to close the door on further rate hikes in coming months."
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