ECB rate hike expectations cool down, Lagarde: Rising long-term rates will suppress growth and inflation

The latest statement from the President of the European Central Bank has noticeably cooled market bets on further ECB tightening.

Christine Lagarde, President of the European Central Bank, stated on Monday that a significant rise in long-term interest rates will slow economic growth and restrain the transmission of energy prices to overall inflation, to an extent exceeding the ECB’s September forecast. She also emphasized that, in the absence of signs of second-round effects, the ECB should take “moderate countermeasures” to control inflation.

As a result, traders have trimmed their bets on further ECB monetary tightening, with market expectations for an ECB rate hike in October now dropping below 40%.

Lagarde pointed out that the current ECB interest rate levels are at the upper end of the “neutral” impact range for the economy, that is, at the top of the 2% to 2.5% band, but she stressed that the ECB’s monetary policy decisions are not based on the neutral interest rate as a reference.

Meanwhile, escalating tensions in the Middle East have pushed oil prices higher, reigniting concerns about the inflation outlook. Investors are currently pricing in nearly four more 25 basis point hikes by the ECB within the next year.

Rising Long Term Rates Replace Rate Hikes

Lagarde noted that, since the last ECB meeting, long-term interest rates have risen significantly, and this trend will help to slow economic expansion and offset the transmission of inflation, with a strength greater than the ECB’s September scenario estimates.

This means that the market’s own rise in rates has, to some extent, played the role of monetary policy tightening, giving the ECB room to pause.

She reiterated that “interest rate trends do not move in lockstep with energy prices,” and the ECB’s policy focus is on whether second-round effects can be detected in advance.

Lagarde pointed out, “because when second-round effects truly appear, it’s already somewhat lagging.” She also stressed that there are currently no “signs that second-round effects may emerge.”

Short-term Inflation Pressure Remains, AI May Help Long-term Inflation Decline

Lagarde said, due to the energy crisis, inflation in the euro areais expected to rise further, but currently there is little evidence that higher energy costs will exacerbate broader price pressures in the economy.

Lagarde also noted: “Artificial intelligence has the potential to help companies increase output. Over time, higher productivity can reduce costs. All else equal, in the long run, this should lower inflationary pressures.”

Data to be released this week is expected to show that eurozone inflation for September will jump from 3.2% in August to 3.7%, well above the 2% policy target. Meanwhile, consumers’ expectations for future price increases rose again last month.

The ongoing Middle East conflict is dimming hopes for a near-term easing of tensions, pushing oil prices higher on Monday and reigniting concerns about rising inflation.

Investors now expect the ECB’s deposit rate to rise by nearly 100 basis points over the next year, in addition to the two hikes already made. If this rate hike path materializes, borrowing costs will reach levels that meaningfully suppress economic activity.

Fiscal Policy Highlighted, ECB Calls for Targeted Assistance

At the fiscal policy level, Lagarde reiterated her criticism of how governments are responding to rising energy prices.

She stated that fiscal support measures should be temporary and precisely targeted at residents and businesses most in need of assistance, but the reality is far from ideal.

“From the observation of the European Commission and ourselves, these measures may not be temporary, nor precisely targeted,” Lagarde said. “They are one-size-fits-all actions and do not focus specifically on the most vulnerable and most impacted groups.”

Her remarks continue the ECB’s longstanding focus on fiscal policy discipline, especially against the backdrop of heavy bond market selloffs that have raised pressure on some fiscally vulnerable euro area member states.