ECB set to raise rates as energy shock keeps inflation above target

The European Central Bank's Governing Council meets on Thursday with a decision that is all but priced in: a 25 basis point increase in the deposit facility rate to 2.25%. What is less certain is whether the bank signals that this is the last move for a while, or whether the energy-driven inflation surprise of the past two months forces a longer tightening cycle than markets currently anticipate.

Energy shock returns to the fore

The immediate catalyst is the jump in energy prices. Eurostat's flash estimate showed headline inflation in the euro area at 3.2% in May, up from 2.4% in April, with the energy component surging 10.9% year-on-year. The bloc remains a heavy net importer of oil and gas, and the escalation of conflict involving Iran has added a fresh risk premium to crude. Brent crude has climbed roughly 15% since early April, and European gas benchmarks have followed, albeit with more volatility.

Unlike the Federal Reserve, which operates under a dual mandate of price stability and maximum employment, the ECB's Treaty obligation is singular: keep inflation below, but close to, 2% over the medium term. That constraint leaves the Governing Council with less room to look through a supply-side shock when it threatens to become embedded in domestic price formation.

Core inflation signals broadening pressure

The more troubling reading for policymakers is core inflation, which strips out energy, food, alcohol and tobacco. It rose to 2.5% in May from 2.1% in April, driven primarily by services. Services inflation is the domestic counterpart to the external energy shock: higher input costs feed into transport, hospitality and business services, and tight labour markets give firms the pricing power to pass them on.

This is what the ECB calls second-round effects. When an external shock triggers wage demands and margin protection that sustain inflation after the initial impulse fades, the central bank must respond even if growth is fragile. The May data suggest that process may already be underway. Wage growth in the first quarter ran at 4.7% year-on-year, according to the ECB's negotiated wage indicator, well above the rate consistent with 2% inflation once productivity trends are accounted for.

Growth outlook deteriorates as policy tightens

The dilemma is that the euro area economy is barely expanding. GDP grew 0.1% in the first quarter of 2026, and high-frequency indicators, purchasing managers' indices, industrial orders, consumer confidence, have softened since March. The manufacturing sector has been in contraction for six consecutive months. Tighter financing conditions are feeding through: bank lending to non-financial corporations contracted in April for the third month running, and the ECB's own bank lending survey shows credit standards tightening at the fastest pace since the sovereign debt crisis.

This is the backdrop to the Governing Council's discussion. A rate increase now risks tipping feeble growth into outright recession, but pausing while inflation is above 3% and core inflation is accelerating would undermine the ECB's credibility. The compromise most observers expect is a hike accompanied by language that keeps options open for July, data-dependent and meeting-by-meeting.

New staff projections will shape the narrative

Thursday's meeting includes the release of the ECB staff macroeconomic projections for the euro area, the first full update since March. These forecasts matter because they anchor the Council's forward guidance. In March, staff saw headline inflation averaging 2.3% in 2026 and 2.0% in 2027, with core inflation at 2.6% and 2.1% respectively. Growth was projected at 0.9% for 2026 and 1.5% for 2027.

Since then, the energy price index used by Goldman Sachs, an average of oil and gas futures, has risen about 12% across the projection horizon. Sven Jari Stehn, chief European economist at Goldman Sachs, wrote at the end of May: "Compared with March, we expect ECB staff to mark down the growth projections for 2026-27 and raise both headline and core inflation projections, reflecting a more persistent energy shock and stronger indirect effects into prices."

Analysts split on the implications for 2027

The 2027 core inflation forecast is the number to watch. Anatoli Annenkov, senior European economist at Société Générale, noted that "this forecast will tell us a lot about the ECB staff's confidence in coming second-round effects, especially taking into account the weakening activity data since March." If staff project core inflation still above 2% in 2027, the case for further tightening after June strengthens considerably.

Mark Wall, director at Deutsche Bank Securities, takes a different view. In research published early this month he wrote: "We expect the ECB to keep rates market pricing relatively unchanged. Interpreting June as a one-off hike won't suit the ECB." His argument is that the Council will want to avoid a premature easing of financial conditions, a drop in market-implied rates, that would counteract the tightening it is delivering. That means the communication must sound hawkish even if the actual rate path is shallow.

Market pricing and the risk of overtightening

Money markets are currently pricing around 65 basis points of additional tightening by December, implying roughly three further 25 basis point moves. That is a significant repricing from April, when the implied terminal rate was barely above 2.5%. The shift reflects both the inflation data and a series of hawkish speeches from Governing Council members, including Isabel Schnabel and Joachim Nagel, who have emphasised that the ECB cannot declare victory until core inflation is convincingly on a downward path.

The risk for the ECB is that financial conditions tighten more than intended. The euro has appreciated about 3% on a trade-weighted basis since the March meeting, and sovereign spreads have widened modestly for the periphery. If the June communication is perceived as signalling a long series of hikes, the euro could strengthen further, importing disinflation but also hurting exports at a time when manufacturing is already weak.

Fiscal policy offers little offset

Unlike in previous cycles, fiscal policy is not available as a cushion. The general escape clause of the Stability and Growth Pact was deactivated at the end of 2023, and the new fiscal rules require debt-reducing adjustment paths from 2025 onwards. Several member states, Italy, France, Belgium, are already under excessive deficit procedures. The European Commission's spring forecast assumes a modest fiscal drag of 0.3% of GDP in 2026, which will deepen if growth disappoints.

This asymmetry, monetary tightening with fiscal consolidation, is a familiar feature of the euro area's policy mix, but it is particularly acute now because the inflation impulse is partly external. The ECB cannot control energy prices, but it must respond to their second-round effects. The result is a policy stance that may be tighter than the domestic economy alone would warrant.