No change to the policy rate: what I will be watching before September

This week my ECB Governing Council colleagues and I decided to leave interest rates unchanged. The Deposit Facility Rate, through which we steer the monetary policy stance, remains at 2.25 per cent.

That decision followed June’s move, when the Governing Council raised rates for the first time since 2023, citing the inflationary pressures stemming from the conflict in the Middle East and its effect on energy prices.

Those inflationary pressures have not gone away. Indeed, following the collapse of the truce and a return to hostilities, there is renewed upward pressure on energy prices. Despite this, the decision not to change rates this week primarily reflects our judgement that, with the effects of the June increase still working through the economy and with limited data since our last meeting, the right course is to observe carefully how the data evolve before drawing further conclusions. With updated projections at our next meeting in September we will be able to more confidently assess the appropriate stance in order to achieve our 2 per cent inflation target over the medium term.

Inflation: a moving picture

The most recent euro area headline inflation estimate for June of 2.8 per cent was lower than some had anticipated, including us. Market surveys and our own analysis had pointed to something closer to 3 per cent. The main driver of the downside surprise was commodity, and primarily energy, prices, which fell through much of June. Since early July, however, energy prices have rebounded, and our latest internal estimate puts euro area inflation back in the region of 3 per cent for the euro area.

A new Staff Insights piece published today by Joe Marlow and Dilan Aydın Yakut (“Nowcasting Euro Area Inflation”) describes our framework for tracking inflation in something closer to real time. The June episode is a good illustration of why this kind of tool matters. The nowcasting model tracked the June cooling as it happened, and has since tracked the reversal. That granularity is useful for the Bank, and I hope for the broader public conversation about where near-term inflation is heading.

What I will be watching before September

July was a non-projection meeting, which means the Governing Council’s next full read of the economic outlook comes in September, including updated staff forecasts. Between now and then, we will have two further euro area inflation prints (for July and August) and a first estimate of Q2 GDP. In the context of ongoing volatility and a wide range of potential outcomes for growth and inflation depending on the path for energy prices (as the scenario analysis in March and June showed), this is meaningful new information.

A few things I will be paying particular attention to. First, whether the recent rebound in energy prices proves sustained or fades. That will be the single biggest determinant of headline inflation in the near term, as we saw more recently. Second, the path of core inflation, which has been more stable but which I do not take for granted, particularly given the typical pattern of staggered wage adjustment in the euro area. This will help us understand the extent to which indirect effects of the energy shock are intensifying or if second-round effects are emerging. Third, growth: the June staff projections put euro area GDP growth at 0.8 per cent for this year, and subject to downside risk. The transmission of June’s rate increase into credit conditions and broader activity will be something we monitor carefully.

The Irish Picture

The Irish economy entered this period of geopolitical uncertainty and energy-market volatility from a strong position, though as I noted in my pre-Budget letter last week, there are underlying vulnerabilities that deserve careful attention as we approach the autumn.

Irish inflation has broadly tracked the euro area pattern, rising sharply in March as energy prices jumped on the start of the war, before falling back a little in June to 3.2 per cent. I have previously mentioned the two channels through which energy reaches consumer prices: a ‘direct’ channel (electricity, gas, home-heating oil and motor fuel) and an ‘indirect’ channel (where energy is an input in the production of goods and services). A recent Central Bank Staff Insights piece by Jonathan Rice and Katie Bourke (“Tracing energy shocks through the Irish supply chain: A new monitoring framework”) quantifies these channels. Because the estimates are static – not attempting to model dynamic supply and demand responses or second-round effects – they provide a clear baseline for monitoring how energy shocks propagate through the economy. Following an increase in energy commodity prices, around one quarter of the estimated increase in price level comes indirectly via the supply chain of non-energy goods and services, with the rest coming from direct effects.

The framework also identifies where these indirect effects are most pronounced. Transport services show the strongest impact, followed by clothing and textiles, transport goods (excluding fuels), household durables, alcohol and tobacco, and food. Labour-intensive services – health, financial services, restaurants and accommodation – show weaker indirect effects, since wages rather than energy and other inputs dominate their cost structures. For these services, how wages respond to the initial shock (the so-called ‘second-round’ effects) will be a factor in determining whether this episode feeds into more persistent, broad-based inflation.

Summing up

The Governing Council acted in June when the data indicated it was necessary. Yesterday’s decision to hold rates was a prudent, considered one. We remain firmly committed to returning inflation to our 2 per cent medium-term target and will continue to be guided by what the evidence tells us, meeting-by-meeting. September’s meeting, with its updated projections and a richer information set, will provide greater clarity on the path ahead. Until then, the data will keep moving, and so will our attention to it. Understanding these transmission channels – direct, indirect, and through wage adjustment – is essential to our assessment of inflation dynamics and our policy response. It is why we will be watching core inflation and wage developments so carefully in the months ahead.

Gabriel Makhlouf