Why we raised rates again and what lies ahead

Yesterday the ECB Governing Council raised interest rates by 25-basis points (0.25 per cent), to 2.5 per cent (the Deposit Facility Rate). 

In this blog I explain why I supported this decision, highlighting the evidence that led me there.

What the data told us

In my July blog, I set out three things I would be watching before September: whether the energy price rebound proved sustained, the path of core inflation, and the extent to which the June rate increase was feeding through to economic activity. The data that arrived over the summer answered some of those questions.

Eurostat’s flash estimate for August put euro area headline inflation at 3.3 per cent, up from 2.9 per cent in July. The rebound in energy prices I flagged in my July blog is showing up in the data. Clearly, energy prices have not faded and, if anything, are proving stickier than previously thought.

Core inflation has been more stable, with a small decline in August to 2.4 per cent on the back of slightly weaker services inflation.

Wage renegotiation takes time – especially in a labour market like this one, where employment growth and churn has slowed – so I expect nominal wage adjustment to this inflation shock to show up with a significant lag. Wage growth of 3.3% in Q2 was broadly in line with expectations, and, near-term, wage trackers point to stabilisation around this level. The delayed pass-through of the energy shock is likely to set a floor on wage growth this year and next.

The latest macroeconomic projections have average wage growth of 3.3 per cent in both 2026 and 2027. This baseline scenario, suggests second-round effects through wages are expected to remain contained. The projections include adverse and severe scenarios which, as well as higher energy prices, assume stronger second-round effects with higher inflation as a result. A milder scenario also allows for a more rapid normalisation of energy prices compared to the baseline.

Thus far, we have mostly seen the direct effects of the energy shock – in fuel for transport and energy. Indirect effects from higher energy prices – in supply chains and firms’ costs – are expected to materialise only gradually in non-energy inflation. However, the current projections envisage smaller indirect effects than during the inflationary episode of 2021-24. Additional upward pressure on food inflation could also come from climate-related factors (El Niño) pushing up commodity prices in the coming months.

All of this points to upward pressures on inflation. And in September’s updated staff projections, which informed this week’s decision, the inflation path was revised upward relative to June, and the return to 2 per cent has been pushed further into the medium term.

Growth has been resilient, both in the face of the energy shock and rising inflation and tighter monetary policy. The latest projections include a small upward revision to euro area GDP growth in 2026 to 0.9 per cent, with some carry-over into 2027 at 1.4 per cent.

The balance of these signals – inflation above target with upward risks, core inflation not yet decisively easing, and resilient growth – suggest a 25-basis point increase in rates as measured policy response.

The path ahead

There remains significant uncertainty to the outlook.

The near-term driver of elevated inflation remains energy: a geopolitical driver more than economic one. A drawn-out conflict in the Middle East risks keeping inflation elevated for a long period.

But the other side of uncertainty is that raising rates a great deal more from here could carry real costs in terms of growth. We are already seeing a tightening of financing conditions, both from changes in policy and other drivers. With a cooling labour market and demand conditions that are weaker than 2021/22, inflationary pressures from the current supply shock are different, and the policy response should reflect that.

What does this mean in practice?

Firstly, it means no pre-commitment to a particular rate path, as set out in yesterday’s decision. Secondly, it points to the sort of evidence I will be paying close attention to: on the persistence of the energy price shock, and the extent to which it is showing up in consumer prices, both directly and indirectly; on wage dynamics; and, on the transmission of previous moves. The Governing Council’s meeting-by-meeting approach, is precisely to gather this evidence. It is the appropriate response to uncertainty about the magnitude and persistence of the shock we are managing.

The Irish picture

The Quarterly Bulletin next week will update our outlook for the Irish economy. Recent data shows growth at a pace consistent with June projections, with 2025 GNI* growth at 4.7 per cent and 2026 activity remaining robust. However, growth is expected to moderate due to higher energy prices dampening consumption, though investment – especially by multi-national firms – should provide offsetting momentum through 2028.

The August headline (HICP) inflation estimate was 3.4 per cent, up from 3.1 per cent in July. Much like the euro area picture, ongoing geopolitical uncertainty means inflation is likely to remain elevated through 2026 and into 2027, with risks of further increases if energy prices spike again or if price pressures spread to food and other goods.

In other news

The monetary policy decision dominates these blogs, and rightly so.

But I also want to draw attention to Central Bank analysis and research that appeared since my last blog in July. This is work that informs our decisions, and I encourage you to read it.

On household investment and capital markets, a new Behind the Data piece by Ciaran Meehan, Brian Power and Philip Corpuz extends our Securities Holdings Statistics to capture, for the first time, Irish household investments held through non-domestic euro area custodians.  The finding that this adds €6.1 billion, or 21 per cent, to measured household security holdings is a methodological step forward that matters for how we assess the depth of Irish capital market participation.

On macroprudential policy and its distributional effects, Anuj Pratap Singh, Francesco Stradi and Fang Yao examine what happened when we recalibrated the loan-to-income limit for first-time buyers in January 2023. They find that there were noticeable differences in the response of first-time buyers to increased borrowing capacity. Some first-time buyers purchased higher value homes, whereas others reduced their downpayments, supporting their liquidity position. This is the kind of granular, policy-relevant work that informs future discussions of the macroprudential framework.

Two complementary publications tackle the economics of residential retrofit from different angles. James Carroll, Derek Lambert, Paul Lyons, Andrew O’Callaghan, Joel Franklin, Daire McCoy, and Bryan Coyne combine loan-level data with actual retrofit cost and energy saving estimates for a large portfolio of Irish dwellings. They find that retrofitting generates net lifetime savings for most households, but that short-term cash flow pressures are a real barrier, particularly for the households who would benefit most. Hannah Ortega-McCormack, James Carroll, Tom Gillespie, and Ronan C. Lyons document a 1.6 per cent average energy efficiency premium in Irish property prices per BER grade, and that this premium has been falling for lower-priced properties and rising for higher-priced ones. Both papers speak directly to the household resilience dimension of the energy shock we are currently navigating.

On Ireland’s intangible economy (PDF 1.98MB), Radek Sauer’s recent paper models how a small lower-tax economy is affected by changes in foreign corporate tax policy. This is directly relevant to the structural questions about Irish GDP and corporate tax revenue. He finds that worldwide taxation of intangible income impacts the Irish corporate tax base more so than domestic tax policy because it reduces the incentive to locate intangibles here.

Finally, on what makes monetary policy transmission stronger or weaker (PDF 2.71MB), Dilan Aydın Yakut, David Byrne and Robert Goodhead ask when do changes in policy rates transmit more or less to financial markets? For the US, transmission weakens as the interest rate and credit cycle matures. For the euro area, sovereign spreads are the dominant amplifier: when spreads are low, the impact of monetary changes on spreads tends to be lower. This goes back to my recent comments on the importance of fiscal discipline for monetary policy.

Gabriel Makhlouf