Today, the Governing Council of the European Central Bank is meeting. Although markets do not expect any changes in interest rates during this meeting, futures contracts show their sensitive reaction to the renewed conflict and expectations of tighter monetary policy later this year.
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The thickening fog of geopolitical uncertainty, agitated financial and unbalanced commodity markets, the impact of increased costs on economic growth, and renewed threats of stagflation significantly complicate the central banks’ key task – ensuring price stability.
The scenario of higher inflation in autumn returns
After a tense spring, when the eurozone’s annual inflation had risen to 3.2 percent, it eased to 2.8 percent in June. However, the renewed conflict between the US and Iran is once again fueling fears of faster price growth.
We immediately felt the initial repercussions on our wallets again when paying for fuel at petrol stations. Increased diesel prices are once again flirting with the psychological barrier of 2 euros per liter, and petrol has also become more expensive. However, what causes greater concern is that with the conflict in the Middle East, broader inflation threats have also re-emerged.
If the conflict gets bogged down and continues for a long time, imbalances in oil and its product markets could penetrate deeper into value chains, affecting food raw materials, goods, and component markets. Not to mention critical scenarios where the dominant problems are no longer affordability, but the physical long-term shortage of critical raw materials.
However, it is reassuring that the global economy met this energy shock in significantly stronger positions than in 2022. A higher interest rate environment led to more moderate economic growth and more sustainable consumption. Supply chains are more flexible, not unbalanced as they were after the pandemic. Europe’s energy system is also more resilient: the diversity of energy sources has increased, and dependence on fossil fuels has decreased. Thus, even if uncertainty in the Persian Gulf persists, this energy shock is expected to remain more concentrated.
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Market participants expect ‘hawkish’ monetary policy decisions in the second half of the year. If a month ago there was strong doubt whether a couple more interest rate hikes would be needed, now interest rate futures show a completely different picture – by the end of the year, the European Central Bank is expected to raise interest rates at least twice. According to today’s market assessments, markets expect the first interest rate hike with an 84% probability on September 10, and the second in December – the probability is significantly lower due to prevailing uncertainty.
These ‘hawkish’ expectations of financial market participants reveal their fears that if the Iran-US conflict and the blockade of the Strait of Hormuz persist, the inflation genie, once again out of the bottle, will rage, and central banks will be forced to react and preempt so-called sticky inflation – the entrenchment of inflationary expectations.
This situation already affects interbank interest rates and, accordingly, the loan servicing costs for those with variable-rate loans. In July, 3 and 6-month EURIBOR interest rates had climbed to their highest level since the winter before last and today stand at 2.48 and 2.69 percent respectively.
Market participants expect the ECB not to change interest rates today, but rather to ‘talk down’ markets and shape expectations, emphasizing the need to closely monitor the macroeconomic environment and, if necessary, open the door for stricter decisions.
