The ECB Prepares to Tighten Into an Energy Shock It Cannot Control
A move to 2.75% is treated as near-certain, with markets attaching a 75% chance of 3.0% by December — even though the inflation is coming from imported fuel.
The European Central Bank is expected to raise its policy rate to 2.75%, with markets attaching roughly a 75% probability to a further increase to 3.0% by December.
The decision is being treated as close to certain. Whether it will work on the inflation actually present in the euro area is a harder question.
Imported inflation
Europe's price pressure is substantially imported. Elevated energy costs stemming from six months of Middle East conflict feed into everything the continent produces, because Europe buys the great majority of its hydrocarbons from abroad.
Higher interest rates suppress domestic demand. They have no effect on the price of a cargo of crude, or on the refinery damage and shipping constraints behind it. Tightening into a supply shock slows the domestic economy while leaving the source of the inflation untouched.
Why the ECB does it anyway
The rationale is about expectations rather than mechanics. If households and firms come to expect persistent above-target inflation, they build it into wage bargaining and pricing decisions — at which point a temporary shock becomes a self-sustaining process.
A central bank that visibly tolerates an overshoot risks that transition. Tightening is the price of preventing it, even when the tightening cannot address the immediate cause.
The European complication
The euro area presents a difficulty the Fed does not face: a single policy rate applied across economies in different conditions. A rate appropriate for one member state can be too tight for another, and the divergence tends to widen exactly when conditions are difficult.
The fiscal picture compounds it. Six member states — Germany, Denmark, the Netherlands, Austria, Finland and Sweden — are pushing for the EU budget to be cut by hundreds of billions and rejecting new common borrowing. Monetary tightening alongside fiscal restraint pulls in the same direction, and the combined effect is larger than either decision considered alone.
What to watch
Not the September move, which is priced. The December decision, and whether the energy shock driving the whole calculation shows any sign of easing before then.