Is Cooling Inflation Just an Illusion? European Central Bank Expected to Hold Rates Tonight, But Hawkish Risks Lurk Behind the Scenes

According to Zhitong Finance APP, after the European Central Bank (ECB) raised rates by 25 basis points in June, there is almost no suspense about tonight’s (July) monetary policy meeting—the ECB will hit the "pause" button on rate hikes, keeping the deposit rate at 2.25%.

However, what really grabs the market's attention is not the current pause, but rather how much room the ECB will leave open for further tightening in September and beyond. With geopolitical tensions in the Middle East reigniting and oil prices back above $90 per barrel, market expectations for further policy tightening have been rekindled.

Rate Pause but Options Remain Open

Since last month’s rate hike and hinting at further action, a series of positive data from the Eurozone—including lower-than-expected inflation, moderate wage growth, and easing price expectations—has significantly decreased the urgency for consecutive rate hikes. However, renewed US-Iran tensions are rapidly rewriting the economic narrative.

Oliver Rakau, an economist at Oxford Economics, characterized this decision as a “hawkish pause,” believing that current data slightly favor further tightening—a stance broadly consistent with the ECB’s forecasts in June and market pricing.

At present, financial markets have already priced in future actions. Traders expect the ECB to complete the remaining rate hikes by February next year at the latest, and see a 60% probability of another hike by mid-year.

According to Jens Eisenschmidt, an economist at Morgan Stanley, if the deposit rate rises to 2.5%, this would already be a "moderately restrictive level." At that point, as inflation approaches target, it would be easy to find reasons to start cutting rates. Therefore, based on the baseline forecast that inflation will just reach target next year and remain slightly below thereafter, "there’s no reason to raise rates more than twice."

However, if Lagarde reiterates at the press conference that there is an “overall consensus” on policy direction, or reminds the public that the June forecasts were based on a total of three rate hikes, market bets on a September hike will be further confirmed.

Second-round Inflation Effects Still Absent, But Food Risks Brewing

The ECB’s confidence to pause and observe mainly comes from the fact that the long-feared “second-round effects” have not yet materialized.

High energy costs usually spill over into other goods and services, driving wage increases and creating a price-wage spiral, but this has not appeared in the data. Eurozone inflation slowed to 2.8% in June, price pressures in services and core inflation (excluding energy and food) both cooled. Wage growth remains moderate, the labor market is generally soft—especially in Germany, the Eurozone's largest economy—and consumers’ future price expectations have also dropped significantly.

Nevertheless, one survey shows that about one-tenth of economists have found evidence of inflation expectations starting to de-anchor, and nearly all respondents express at least some concern about second-round effects. ECB policymakers also believe that even if these effects are more delayed and moderate, they will still arrive, and the central bank needs to be ready to act at any time.

More complicated is the fact that extreme heat and the El Niño phenomenon, which have swept across many European countries this summer, may have already damaged crops and pushed up future food prices. Critically low water levels in major waterways like the Rhine may also cause shipping bottlenecks. Barclays warns in a report that despite overall food inflation dropping in recent months, abnormal heat could press food prices upward again.

Middle East Changes Disturbing the Risk Balance: How Will Lagarde Walk the Tightrope?

After the June rate meeting, there was a brief ceasefire between the US and Iran, coupled with inflation data surprising to the downside, which once led the market to hope the worst was over. However, as hostilities reignited and oil prices again stabilized above $90/barrel, expectations of tighter policy have made a comeback. This means the ECB not only faces the question of “how much more to hike,” but must also clarify its judgment on the risk balance.

Lagarde will inevitably be asked how the Eurozone economy has performed compared to the baseline and more pessimistic scenarios set in June. While oil prices have recently risen, if one considers futures curves, the level is still close to a relatively soft path that would enable faster inflation declines; in contrast, natural gas prices align more with the adverse scenario.

Previously, thanks to a brief ceasefire, Lagarde said in early July that inflation risks were "more balanced" than at the time of the June rate hike; now, with conflict flaring again, whether this wording will be adjusted becomes a key detail for the market to catch policy signals. Meanwhile, the ECB must also confront long-term headwinds—ongoing trade tensions, high energy costs, and China’s continued expansion in several key export markets all mean Eurozone industry will face persistent pressure in coming years, which will dampen labor demand and exert downward pressure on wages and prices.

Beyond Monetary Policy: Lagarde's Personal Career Moves Add Uncertainty

In addition to economy and rate paths, Lagarde’s press conference will inevitably face questions about her own future. This

French president has sparked ongoing speculation—that she may step down before her term expires in October next year. Lagarde herself recently admitted that, as early as February this year when inflation neared the 2% target, she had considered leaving early, but the subsequent US strikes on Iran made her stay.

Recently, she announced plans to participate in French election activities in some capacity to boost European issues' visibility, while stating she won't personally seek public office. At the same time, rumors swirl about her potentially becoming the permanent head of the World Economic Forum at Davos. Such personnel uncertainty adds an extra layer of sensitivity to the ECB’s future policy communication.