A projection of the Euro currency sign is displayed in front of the headquarters of the European Central Bank (ECB) in Frankfurt am Main, western Germany, on Dec. 30, 2025.
Kirill Kudryavtsev Afp | Getty Images
European Central Bank policymakers are facing a dilemma as efforts to combat inflationary pressures with interest rates mount at the risk of plunging the fragile eurozone economy into recession – but they may not have to lift a finger.
Market expectations of tighter monetary policy to come – meaning rate hikes – are already creating restrictive conditions for financing and lending, according to European economist at Goldman Sachs Alexandre Stott.
“The transfer of strict policy is already underway,” he wrote in an analysis published on Wednesday.
“Bank lending standards – particularly important in the euro area, where loans account for more than half of all corporate capital – are already very tight and are likely to tighten,” said Stott, adding that the challenge is testing how much restrictions are passed on to the economy.
“On the other hand, many of the ongoing restrictions are made due to the expectation of a high level of policy. [ECB’s] Therefore, the Executive Council will have to deliver at least some of the expected things if they want to measure the amount demanded and depend on the pressure of inflation,” he said.
“On the other hand, about a quarter of the economic pull appears to be abnormal from monetary policy expectations, reducing the need to tighten policy significantly. This would be balanced, supports a cautious approach to raising rates, and is consistent with our forecast of two 25-point increases in June and September.”
Market expectations
Markets are pricing in a high probability (around 91%) of a 25 basis point interest rate hike at the next ECB meeting on June 11 – which will take the bank’s key deposit rate to 2.25% – and a 50% chance of another rate hike later this year in September.
The rise in prices appeared to increase as consumer prices rose in the euro area due to the war in Iran, where inflation in the euro area exceeded 3% from April. The next inflation print should take place on June 2.
ECB policymakers reiterated central bank President Christine Lagarde’s stance, saying they would take a data-driven and consensus-based approach to monetary policy. ECB Vice President Luis De Guindos told CNBC on Wednesday that central banks should weigh the need to reduce inflation without piling too much pressure on economic output.
“I think there’s no kind of fait accompli about the emergence of standards. The conversation will be open and all elements will be weighed and considered,” he told CNBC’s Annette Weisbach.
Bank of France Governor Francois Villeroy de Galhau, who is also on the ECB’s Governing Council, told CNBC earlier this week that European policymakers will “do what it takes” to return inflation to 2%.
The credibility of the ECB is at stake
Economists are divided on whether the ECB should raise rates, given anemic euro zone growth; the latest data pointed to an increase of 0.1% in the first quarter.
Holger Schmieding, chief economist at Berenberg, said last week that the “big three” economies of Europe – Germany, France and Italy – have been weakened by rising energy costs, leading to a deflationary situation characterized by high inflation and unemployment, as well as weak growth.
Schmieding said the destruction of demand should “take care” of the inflationary part of the stagflation problem, as consumers spend less on other things to cover higher energy costs – ignoring the need for stronger stimulus.
“It’s important to distinguish between what the central banks would unfortunately do and what would be the right thing to do,” Schmieding told CNBC last week, adding: “My view is that the European Central Bank is going to make a big mistake.”
Filippo Alloatti, head of Financials for Credit at Federated Hermes, said in his analysis on Thursday that the ECB is caught between a rock and a hard place.
“The economic impact of disrupted energy infrastructure in the Middle East is serious and uncertain. Even if tensions ease, it is likely that oil prices will remain structurally high,” he said, with countries like Germany and Italy particularly vulnerable to long-term energy cost shocks.
“At the same time, the ECB is dealing with the legacy of previous policy mistakes that kept interest rates so low for so long after the pandemic,” he added.
“As a result, the central bank is now under increasing pressure to react strongly to inflationary pressures and the results of the second round. Expectations of fixed inflation have become a priority, and this points to the need for a 25 basis point increase … in early June.”
Ultimately, the bank’s credibility is at stake, Alloatti said.
“Any doubt threatens confidence in its ability to maintain price stability, which, once lost, can be difficult to regain. The ECB needs to balance growth risks against inflationary pressures while strengthening its commitment to financial and financial stability in an uncertain global environment.”
— CNBC’s Hugh Leask and Chloe Taylor contributed to this report.
