ECB keeps interest rates unchanged after debating possible hike

Warning lights over inflation are flashing brighter across the euro zone, and while the European Central Bank kept interest rates on hold as expected today, it made clear that pressure is building for rate cuts to give way to hikes, with markets now looking to June for the first move.

Inflation climbed to 3% this month, comfortably above the bank’s 2% target, and policymakers now face the prospect of further acceleration after the Iran war drove oil prices to their highest level in four years.

ECB President Christine Lagarde said the decision to leave rates unchanged had been unanimous, but she also revealed that policymakers had discussed a possible rate increase “at length” during their meeting.

“We made an informed decision based on as-yet insufficient information,” she said, adding that the central bank’s next gathering in June would be the “right time” to reassess the outlook.

Earlier, the ECB said in a statement that risks had worsened on both fronts, with inflation threats rising while the outlook for growth weakened.

“The longer the war continues and the longer energy prices remain high, the stronger is the likely impact on broader inflation and the economy,” it said.

The bank added that longer-term inflation expectations were still well anchored, even as expectations over shorter time frames had risen sharply.

Even so, any tightening cycle is expected to be gentler than the one seen in 2022, when the ECB raised its key rate by a total of 450 basis points in just one year to contain surging prices.

This time, the backdrop looks less severe: price pressures are weaker, second-round inflation effects have yet to emerge, the labour market has softened, borrowing costs are already starting from a higher level, and growth is hovering near a standstill.

In fact, the euro zone economy barely expanded in the first quarter, before the war had begun to leave any meaningful mark.

Meanwhile, underlying or core inflation, closely watched for signs that price growth is becoming entrenched, eased to 2.2% in April from 2.3%, indicating that second-round effects are still not taking hold in any significant way.

That leaves the ECB walking a narrow path.

Energy shock to hurt growth

Some economists estimate the energy shock alone could shave as much as 0.5 percentage point off economic growth, roughly half of the bloc’s projected expansion over the coming year.

The second quarter already appears bleak because of the war, and Germany, the bloc’s largest economy, could even slip into contraction.

Still, Lagarde rejected comparisons with an earlier era of economic malaise, saying the label “stagflation” did not fit the current moment. “That is a term better to be parked in the 1970s,” she said in response to a question.

Fresh surveys this week painted a darker picture than expected, showing business sentiment falling faster than forecast, the services sector weakening, corporate profits shrinking, exports still suffering from tariffs, and banks preparing to tighten firms’ access to credit.

Yet central bankers around the world have argued that waiting six weeks to move on rates makes little practical difference, and that a brief pause can offer greater clarity on how inflation is evolving.

The Bank of Japan, the US Federal Reserve, the Bank of Canada and the Bank of England also kept rates unchanged this week, despite voicing concern about price pressures.

But the lingering “memory effect” from the last inflation surge may complicate that caution for policymakers.

Because it was the first major inflation shock in decades, consumers may react faster this time, particularly after workers suffered a sharp real-terms wage squeeze during the 2021/2022 episode.

“The experience of inflation is so recent that businesses will raise prices sooner than in 2022, and even workers will try to secure higher wages sooner, which will likely accelerate inflation developments,” said Lorenzo Codogno of LC Macro Advisors.