An ECB rate hike is ‘all but certain’ — but investors divided on what comes next

The European Central Bank is widely expected to raise interest rates on Thursday, but uncertainty around the U.S.-Iran war is clouding the outlook for its longer-term policy path, market watchers say.

Markets are pricing in a 100% chance of the ECB raising its key interest rate by at least 25 basis points, according to LSEG data.

ECB officials have said since the U.S.-Iran war broke out that they would take a meeting-by-meeting approach to monetary policy.

Its September meeting comes days after data showed inflation in the euro zone hit 3.3% in August, with energy inflation surging to 14.3%.

The euro zone, a net importer of energy, has seen inflation above the ECB's 2% target since the war in the Middle East threatened commodity transit through the Strait of Hormuz, causing oil prices to spike and remain volatile.

Government borrowing costs have also risen drastically in recent weeks, with European bond yields hitting multi-decade highs as intensifying conflict in the Middle East led investors to price in higher inflation and rate hikes.

Euro zone 10-year government bond yields

The ECB raised rates in June for the first time since 2023, bringing its key interest rate to 2.25% and making it the first major central bank to enact a hike in response to the war.

ECB President Christine Lagarde said at the time that there were upside risks for inflation and downside risks for economic growth, but she stressed that policymakers are "not pre-committing to a particular rate path."

The ECB held interest rates steady at its subsequent meeting, with its Governing Council saying it was "closely monitoring the intensity and duration of the [energy] shock, as well as its indirect and second-round effects."

Felix Feather, an economist at Aberdeen, said in a Wednesday note that an ECB hike was "all but certain," adding that the more important question is whether the bank's tone implies to the market that it's the next step of a protracted tightening cycle.

"The tone is likely to be hawkish," Feather said. "The eurozone economy has proved more resilient than the ECB expected, while high energy prices, stronger forward-looking wage trackers, and somewhat elevated market-based inflation expectations will keep policymakers focused on upside risks."

While he noted that the ECB is likely to revise its growth forecasts higher because the economic fallout from the war has been more limited than projected, Feather said there also remains "a path to a protracted hold of interest rates at 2.5%" after Thursday's meeting.

"Underlying inflation measures have continued to ease, wage pressures remain relatively contained and there is still only sparse evidence that the energy shock is generating widespread second-round effects," he said.

"However, this would probably require the US and Iran to de-escalate tensions in the Middle East to ease energy markets, something that doesn't seem imminent at the present moment."

Jonathan Pryor, co‑head of dealing and head of private markets at Marex FX, warned in a note on Wednesday that the ECB could "get caught out" after Thursday's decision.

"If the ECB does miscalculate a 'one and done' and gets left behind by G10 peers with higher interest rates, it could have long-term impacts on Lagarde's and the ECB's reputation," he said.

"The added complexity for the ECB will be the lesser-spoken-about challenge of accommodating undulating bond spreads across sovereign states whilst coordinating monetary policy," he added. 

"Any comment relating to the bond market will be important, as it is typically a place the ECB doesn't like to go, but an inevitable element of the challenges they face in the months ahead."

Uncertainty around the ECB's rate path has divided investors: a survey by Deutsche Bank of its clients over the past week showed no consensus about where Thursday's decision will sit in the central bank's hiking cycle.

Deutsche Bank economists said in a note on Tuesday that more than a third of respondents agreed with their view that the ECB would take its key rate to 2.75%, while one in four saw just one more hike on the horizon.

They added that another quarter of respondents saw the cycle ending with a 3% terminal rate, suggesting three more hikes before the ECB's tightening cycle is through.