To raise interest rates or not? The European Central Bank's dilemma: Can shrinking demand "solve" inflation on its own?
2026-05-29 16:37:35
The minutes of the European Central Bank’s April meeting, released on Thursday (May 28), showed that the decision to keep interest rates unchanged last month was a “difficult choice” for some policymakers; given persistently high signs of inflation, they could hardly ignore the shock caused by energy factors.
The European Central Bank has kept interest rates unchanged for the past year, but last month it discussed raising rates as soaring energy costs pushed inflation far above its 2% target, prompting several policymakers to signal the need for action.
The European Central Bank (ECB) stated in its meeting minutes: "Several members indicated that they would not object if a rate hike were included on the agenda for this meeting." The ECB also stated: "The value of 'pausing rate hikes to preserve policy options' has diminished since the last meeting."
The European Central Bank is facing a dilemma in its interest rate decision-making: raising interest rates could plunge the fragile eurozone economy into recession, but market expectations of a rate hike have already tightened financial conditions.
Goldman Sachs points out that the transmission of tighter policies "is already underway," with bank lending standards having tightened significantly, and about a quarter of the drag coming from factors unforeseen by monetary policy, supporting a "cautious rate hike" approach.
Market pricing indicates a 91% probability of a 25 basis point rate hike in June (at which time the deposit facility rate will rise to 2.25%), and a 50% probability of another rate hike in September.
However, Berenberg's chief economist warned that the European Central Bank might make a "big mistake," arguing that shrinking demand itself could alleviate inflation. Meanwhile, Hermès emphasized that hesitation would jeopardize the central bank's credibility, making a June rate hike inevitable.
European Central Bank policymakers face a dilemma: raising interest rates to curb inflationary pressures could plunge the fragile eurozone economy into recession—but they may not need to lift a finger at all.
Goldman Sachs European economist Alexander Stott points out that market expectations of an upcoming tighter monetary policy (i.e., interest rate hikes) have already led to more restrictive financial and lending conditions. In an analysis report released Wednesday, he wrote, "The transmission of tighter policy is already underway."
Stott stated, "Bank lending standards—which are particularly important in the eurozone because loans account for more than half of total corporate financing—have tightened significantly and are likely to tighten further." He added that the challenge lies in assessing how much of these restrictions are being transmitted to the real economy.
"On the one hand, most of the restrictive measures currently in place can be attributed to expectations of higher policy rates. Therefore, if the ECB Governing Council wants to curb demand and combat inflationary pressures, it will need to at least realize some of the expected rate hikes."
"On the other hand, the economic drag of about a quarter appears to be due to factors outside of monetary policy expectations, which reduces the need for a sharp tightening of policy," Stott said. All else being equal, this observation supports a cautious approach to interest rate hikes and is consistent with their forecast of 25 basis point increases in June and September.
Market pricing indicates a high probability (approximately 91%) of a 25 basis point rate hike by the European Central Bank at its next meeting on June 11, which would bring the key deposit facility rate to 2.25%. The market also prices in a 50% chance of another rate hike later this year (September).
Eurozone consumer prices have soared due to the war with Iran, making interest rate hikes increasingly necessary—the eurozone inflation rate jumped to 3% in April. The next inflation data will be released on June 2.
However, given the eurozone’s sluggish growth—the latest figures show expansion of only 0.1% in the first quarter—economists are divided on whether the European Central Bank should raise interest rates.
Holger Schmidt, chief economist at Berenberg, said last week that Europe’s “big three economies”—Germany, France and Italy—are weakening due to soaring energy costs, creating a stagflation environment characterized by rising inflation and unemployment and slowing growth.
Schmidt believes that shrinking demand should "self-solve" the inflationary portion of stagflation, as consumers will spend less on other items to pay for higher energy costs—thus eliminating the need for aggressive tightening. He told CNBC, "My impression is that the ECB is going to make a big mistake."
European Central Bank (ECB) policymakers reiterated President Christine Lagarde's stance, stating that monetary policy will be developed through a data-dependent and meeting-by-meeting approach. ECB Vice President Guindos told CNBC on Wednesday that central banks must avoid putting excessive pressure on economic output while curbing inflation.
He said, "I don't think there's anything set in stone regarding the evolution of interest rates. The discussion will be open, and all factors will be balanced and taken into account." Earlier this week, French central bank governor Villeroy told CNBC that European policymakers "will take the necessary steps" to bring inflation back to the 2% target.
In an analysis report on Thursday, Filippo Aloiti, head of credit at All Hermès, said the European Central Bank is in a "dilemma." He stated, "The economic impact of the disruption to Middle Eastern energy infrastructure is severe and uncertain. Even if tensions ease, oil prices are still very likely to remain structurally high."
He added, "At the same time, the ECB is facing the legacy of previous policy mistakes—keeping interest rates too low for too long after the pandemic. Therefore, the central bank is now under increasing pressure to act decisively to address inflationary pressures and the second round of effects."
Aloiti stated, "Anchoring inflation expectations has become a top priority, which suggests the need for a 25 basis point rate hike in June... Any hesitation could undermine confidence in its ability to maintain price stability, and once that confidence is lost, it is difficult to regain. The ECB needs to strike a balance between growth risks and inflationary pressures, while reinforcing its commitment to financial and monetary stability in an uncertain global environment."
The European Central Bank is facing a dilemma in its interest rate decision-making: raising interest rates could plunge the fragile eurozone economy into recession, but market expectations of a rate hike have already tightened financial conditions.
Goldman Sachs points out that the transmission of tightening policies "is already underway," with bank lending standards having tightened significantly, and about a quarter of the drag coming from factors unforeseen by monetary policy expectations. This supports the forecast of 25 basis point rate hikes in June and September. Market pricing indicates a probability of about 91% for a June rate hike.
However, Berenberg warned that the European Central Bank might make a "big mistake," arguing that shrinking demand itself could alleviate inflation.
Hermès, however, emphasized that hesitation would jeopardize the central bank's credibility, making a June rate hike inevitable. European Central Bank officials reiterated their commitment to a data-dependent, meeting-by-meeting decision-making approach. Ultimately, the central bank's credibility is on the balance.
In terms of currency market performance, the euro traded around 1.1640 against the US dollar during the Asian session on Friday (May 29), showing an overall trend of bottoming out and rebounding this week. On Thursday, it briefly fell below 1.16 due to the escalating conflict between the US and Iran, but subsequently recovered its losses thanks to the hawkish minutes from the European Central Bank. The market has largely priced in a June rate hike by the ECB (with a pricing probability of approximately 91%), therefore the euro's rebound after the release of the minutes was limited.
(Euro/USD daily chart, source: FX678)
From the daily chart, the EUR/USD pair is currently in a consolidation phase after a pullback from its highs and a double bottom, with the price hovering around the 1.1646 level. In the short term, it is suppressed by the 20-day moving average (MA20) (1.1672), while in the medium term, it is supported by the 50-day, 100-day, and 200-day moving averages, indicating a balance between bullish and bearish forces. After previously rising to a high of 1.2081, it fell back, reaching a low of 1.1410, before rebounding to 1.1848. Currently, it is fluctuating within the 1.1575-1.1696 range, with no clear direction. The MACD indicator shows the DIFF line has just crossed above the DEA line, and the histogram has turned from green to red, indicating a waning of downward momentum and a slight recovery in short-term bullish strength. However, the red bars are relatively short, suggesting that upward momentum has not yet been fully released.
At 15:57 Beijing time on May 29, the euro was trading at 1.1640/41 against the US dollar.
The European Central Bank has kept interest rates unchanged for the past year, but last month it discussed raising rates as soaring energy costs pushed inflation far above its 2% target, prompting several policymakers to signal the need for action.
The European Central Bank (ECB) stated in its meeting minutes: "Several members indicated that they would not object if a rate hike were included on the agenda for this meeting." The ECB also stated: "The value of 'pausing rate hikes to preserve policy options' has diminished since the last meeting."
The European Central Bank is facing a dilemma in its interest rate decision-making: raising interest rates could plunge the fragile eurozone economy into recession, but market expectations of a rate hike have already tightened financial conditions.
Goldman Sachs points out that the transmission of tighter policies "is already underway," with bank lending standards having tightened significantly, and about a quarter of the drag coming from factors unforeseen by monetary policy, supporting a "cautious rate hike" approach.
Market pricing indicates a 91% probability of a 25 basis point rate hike in June (at which time the deposit facility rate will rise to 2.25%), and a 50% probability of another rate hike in September.
However, Berenberg's chief economist warned that the European Central Bank might make a "big mistake," arguing that shrinking demand itself could alleviate inflation. Meanwhile, Hermès emphasized that hesitation would jeopardize the central bank's credibility, making a June rate hike inevitable.
The European Central Bank's dilemma: to raise interest rates or not?
European Central Bank policymakers face a dilemma: raising interest rates to curb inflationary pressures could plunge the fragile eurozone economy into recession—but they may not need to lift a finger at all.
Goldman Sachs European economist Alexander Stott points out that market expectations of an upcoming tighter monetary policy (i.e., interest rate hikes) have already led to more restrictive financial and lending conditions. In an analysis report released Wednesday, he wrote, "The transmission of tighter policy is already underway."
Loan standards have tightened, and the transmission is underway.
Stott stated, "Bank lending standards—which are particularly important in the eurozone because loans account for more than half of total corporate financing—have tightened significantly and are likely to tighten further." He added that the challenge lies in assessing how much of these restrictions are being transmitted to the real economy.
"On the one hand, most of the restrictive measures currently in place can be attributed to expectations of higher policy rates. Therefore, if the ECB Governing Council wants to curb demand and combat inflationary pressures, it will need to at least realize some of the expected rate hikes."
External factors contributed about a quarter of the drag, supporting a cautious approach to interest rate hikes.
"On the other hand, the economic drag of about a quarter appears to be due to factors outside of monetary policy expectations, which reduces the need for a sharp tightening of policy," Stott said. All else being equal, this observation supports a cautious approach to interest rate hikes and is consistent with their forecast of 25 basis point increases in June and September.
Market pricing indicates a high probability (approximately 91%) of a 25 basis point rate hike by the European Central Bank at its next meeting on June 11, which would bring the key deposit facility rate to 2.25%. The market also prices in a 50% chance of another rate hike later this year (September).
Inflationary pressures are rising, but economic growth remains sluggish.
Eurozone consumer prices have soared due to the war with Iran, making interest rate hikes increasingly necessary—the eurozone inflation rate jumped to 3% in April. The next inflation data will be released on June 2.
However, given the eurozone’s sluggish growth—the latest figures show expansion of only 0.1% in the first quarter—economists are divided on whether the European Central Bank should raise interest rates.
Berenberg warns: The European Central Bank may have made a "big mistake".
Holger Schmidt, chief economist at Berenberg, said last week that Europe’s “big three economies”—Germany, France and Italy—are weakening due to soaring energy costs, creating a stagflation environment characterized by rising inflation and unemployment and slowing growth.
Schmidt believes that shrinking demand should "self-solve" the inflationary portion of stagflation, as consumers will spend less on other items to pay for higher energy costs—thus eliminating the need for aggressive tightening. He told CNBC, "My impression is that the ECB is going to make a big mistake."
European Central Bank officials stated: Data-dependent, decisions to be made at each meeting.
European Central Bank (ECB) policymakers reiterated President Christine Lagarde's stance, stating that monetary policy will be developed through a data-dependent and meeting-by-meeting approach. ECB Vice President Guindos told CNBC on Wednesday that central banks must avoid putting excessive pressure on economic output while curbing inflation.
He said, "I don't think there's anything set in stone regarding the evolution of interest rates. The discussion will be open, and all factors will be balanced and taken into account." Earlier this week, French central bank governor Villeroy told CNBC that European policymakers "will take the necessary steps" to bring inflation back to the 2% target.
Hermès in partnership: Reputation hanging by a thread, a June rate hike is inevitable.
In an analysis report on Thursday, Filippo Aloiti, head of credit at All Hermès, said the European Central Bank is in a "dilemma." He stated, "The economic impact of the disruption to Middle Eastern energy infrastructure is severe and uncertain. Even if tensions ease, oil prices are still very likely to remain structurally high."
He added, "At the same time, the ECB is facing the legacy of previous policy mistakes—keeping interest rates too low for too long after the pandemic. Therefore, the central bank is now under increasing pressure to act decisively to address inflationary pressures and the second round of effects."
Aloiti stated, "Anchoring inflation expectations has become a top priority, which suggests the need for a 25 basis point rate hike in June... Any hesitation could undermine confidence in its ability to maintain price stability, and once that confidence is lost, it is difficult to regain. The ECB needs to strike a balance between growth risks and inflationary pressures, while reinforcing its commitment to financial and monetary stability in an uncertain global environment."
The European Central Bank is facing a dilemma in its interest rate decision-making: raising interest rates could plunge the fragile eurozone economy into recession, but market expectations of a rate hike have already tightened financial conditions.
Goldman Sachs points out that the transmission of tightening policies "is already underway," with bank lending standards having tightened significantly, and about a quarter of the drag coming from factors unforeseen by monetary policy expectations. This supports the forecast of 25 basis point rate hikes in June and September. Market pricing indicates a probability of about 91% for a June rate hike.
However, Berenberg warned that the European Central Bank might make a "big mistake," arguing that shrinking demand itself could alleviate inflation.
Hermès, however, emphasized that hesitation would jeopardize the central bank's credibility, making a June rate hike inevitable. European Central Bank officials reiterated their commitment to a data-dependent, meeting-by-meeting decision-making approach. Ultimately, the central bank's credibility is on the balance.
In terms of currency market performance, the euro traded around 1.1640 against the US dollar during the Asian session on Friday (May 29), showing an overall trend of bottoming out and rebounding this week. On Thursday, it briefly fell below 1.16 due to the escalating conflict between the US and Iran, but subsequently recovered its losses thanks to the hawkish minutes from the European Central Bank. The market has largely priced in a June rate hike by the ECB (with a pricing probability of approximately 91%), therefore the euro's rebound after the release of the minutes was limited.
(Euro/USD daily chart, source: FX678)
From the daily chart, the EUR/USD pair is currently in a consolidation phase after a pullback from its highs and a double bottom, with the price hovering around the 1.1646 level. In the short term, it is suppressed by the 20-day moving average (MA20) (1.1672), while in the medium term, it is supported by the 50-day, 100-day, and 200-day moving averages, indicating a balance between bullish and bearish forces. After previously rising to a high of 1.2081, it fell back, reaching a low of 1.1410, before rebounding to 1.1848. Currently, it is fluctuating within the 1.1575-1.1696 range, with no clear direction. The MACD indicator shows the DIFF line has just crossed above the DEA line, and the histogram has turned from green to red, indicating a waning of downward momentum and a slight recovery in short-term bullish strength. However, the red bars are relatively short, suggesting that upward momentum has not yet been fully released.
At 15:57 Beijing time on May 29, the euro was trading at 1.1640/41 against the US dollar.
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