A projection of the euro currency symbol is photographed on the facade of the European Central Bank (ECB) headquarters in Frankfurt am Main, western Germany, on December 30, 2025.
Kirill Kudryavtsev | AFP | Getty Images
European Central Bank policymakers face a dilemma as efforts to counter inflationary pressures by raising interest rates risk pushing the fragile eurozone economy into recession, but they may not need to do anything.
Alexander Stott, European economist at Goldman Sachs, said market expectations for future monetary tightening, or interest rate hikes, were already causing further constraints on the financial and lending environment.
“Transmission of tightening policy has already begun,” he said in an analytical note published Wednesday.
“Bank lending standards, which are particularly important in the eurozone where loans account for more than half of all corporate lending, have already been significantly tightened and are likely to become even stricter in the future,” Stott said, adding that the challenge was to assess the extent to which the restrictions were spilling over into the economy.
“On the other hand, most of the ongoing restrictions are due to expectations of higher policy rates. Therefore, if the (ECB) Governing Council wants to squeeze demand and counter inflationary pressures, it will need to implement at least some of the expected rate hikes,” he said.
“Meanwhile, about a quarter of the drag on the economy appears to be exogenous to monetary policy expectations, reducing the need for policy tightening significantly. All else being equal, this supports a cautious approach to rate hikes and is consistent with our expectations for two 25 basis point hikes in June and September.”
market expectations
Markets have priced in a high probability (around 91%) of a 25 basis point rate hike at the ECB’s next meeting on June 11th, which would bring the ECB’s main deposit facility rate to 2.25%, with a 50% chance of a further rate hike later this year in September.
Consumer prices in the euro area are rising due to the impact of the Iran war, and the inflation rate in the euro area has risen to 3% as of April, making it more likely that interest rates will be raised. The next inflation printing is scheduled for June 2nd.
ECB policymakers said they would rely on data and take a meeting-by-meeting approach to monetary policy, reiterating central bank President Christine Lagarde’s position. ECB Deputy President Luis Deguindos told CNBC on Wednesday that the central bank needs to consider the need to contain inflation without putting too much pressure on economic output.
“I don’t think there is any fait accompli in terms of where interest rates will go. The discussion will be open and all factors will be balanced and considered,” he told CNBC’s Annette Weisbach.
Banque de France Governor François Villeroy de Galault, who is also a member of the ECB’s executive board, told CNBC earlier this week that European policymakers “will do what is necessary” to return inflation to the 2% target.
ECB credibility at risk
Economists are divided on whether the ECB should raise interest rates at all, given weak economic growth in the euro area. The last data showed growth of just 0.1% in the first quarter.
Holger Schmieding, chief economist at Berenberg, said last week that Europe’s “big three” economies (Germany, France and Italy) have been weakened by recent spikes in energy costs, leading to an environment of stagflation characterized by rising inflation, unemployment and slowing growth.
Mr Schmieding said consumers should “address” the inflation part of the stagflation dilemma through demand destruction, as they reduce spending on other items to cover rising energy costs, negating the need for aggressive tightening.
“Unfortunately, it’s important to distinguish between what central banks are likely to do and what is right,” Schmieding told CNBC last week, adding: “My impression is that the European Central Bank will make a big mistake.”
Filippo Alloatti, head of credit finance at Federated Hermes, said in an analytical note on Thursday that the ECB is caught in the middle.
“The economic consequences of disruptions to the Middle East’s energy infrastructure are severe and uncertain. Even if tensions ease, oil prices are likely to remain structurally high,” he said, adding that countries such as Germany and Italy are particularly vulnerable to long-term energy cost shocks.
“At the same time, the ECB is grappling with the legacy of its past policy mistakes of keeping interest rates too low for too long after the pandemic,” he added.
“As a result, the central bank is now under increasing pressure to respond decisively to inflationary pressures and second-order impacts. Consolidation of inflation expectations is paramount, indicating a need for a 25 basis point rate hike as early as June.”
Alloatti said ultimately the bank’s credibility is at stake.
“If we hesitate, we risk eroding confidence in our ability to maintain price stability, which once lost is difficult to recover.The ECB needs to balance growth risks and inflationary pressures while stepping up its commitment to monetary and financial stability in an uncertain global environment.”
—CNBC’s Hugh Leask and Chloe Taylor contributed to this report.
