Oil prices return to $85, and market bets on further ECB rate hikes intensify.

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The situation in the Strait of Hormuz has escalated again, causing international oil prices to rebound rapidly and the previously clear path of the European Central Bank's policy to fall back into uncertainty.

On July 15, according to CNBC, Joachim Nagel, President of the German Bundesbank and member of the European Central Bank's Governing Council, said, the escalation of conflict in the Middle East and rising oil prices have brought “extremely high uncertainty” to the economic outlook. The ECB will remain vigilant and take action when necessary. This statement has reinforced market expectations that the ECB may continue to tighten policy.

Currently, the market still expects the ECB to keep rates unchanged at the July 22 meeting, but rate swaps show the probability of a 25 basis point hike at this meeting has risen to about 20%. Investors are still betting on a cumulative 50 basis point hike before spring next year, which would lift the deposit rate to 2.75%.

Oil price rebound disrupts the pace of falling inflation

As military conflict between the US and Iran over the Strait of Hormuz continues to escalate, international oil prices have rebounded sharply.

Brent crude has climbed back above $85 per barrel, while it had hovered near $70 just a week ago. For the eurozone, which is highly dependent on imported energy, this means the process of declining inflation may be once again impacted. Data shows that around 57% of the eurozone's energy consumption in 2024 depends on imports, making oil price fluctuations particularly impactful on overall inflation.

In fact, just before the Middle East conflict erupted, eurozone inflation had basically fallen to around the ECB's 2% target. But then, surging energy prices briefly pushed overall inflation up to 3.2%. Latest data shows that despite energy prices rising 8.7% year-on-year, eurozone’s overall inflation in June fell back to 2.8%, with core inflation keeping at 2.4%, indicating the energy shock has not fully transmitted to other sectors.

However, with oil prices soaring again this week, the market is beginning to worry whether the downward trend in inflation can continue. The ECB’s previous judgment on inflation improvements also faces a new test.

Policy meeting faces a "data vacuum"

Compared to previous occasions, this July 22 meeting faces a unique challenge.

The initial reading of eurozone Q2 GDP and July inflation will be released on July 30 and 31, respectively, which means the ECB will decide monetary policy amid a lack of the latest economic and inflation data.

ING rate strategists Michiel Tukker and Benjamin Schroeder wrote in their latest report that the soon-to-be-released eurozone inflation data will be "a key variable for testing hawkish market pricing," but even if the data is mild, it may not be enough to dispel market concerns about secondary inflation risks triggered by energy prices.

The two analysts believe that, the policy paths of the ECB and the Fed may diverge further: US inflation pressure is more likely to ease, while the peak of eurozone inflation may not have appeared yet, especially if energy prices continue to rise.

ECB faces dilemma between inflation and recession

The biggest challenge for the ECB currently is to strike a balance between curbing inflation and avoiding recession.

In the first half of this year, the ECB cut rates four times in a row, bringing the deposit rate down from 3% to 2%. As energy prices pushed inflation pressures back up, the central bank unexpectedly hiked rates by 25 basis points in June, reversing the policy direction.

Meanwhile, the eurozone economy remains sluggish. GDP declined 0.2% year-on-year in Q1, and many policymakers worry that further tightening of monetary policy may drag the economy down further and push the eurozone into recession.

Austrian central bank governor Martin Kocher said Wednesday, the ECB is currently focusing on indirect price effects and potential secondary impacts from the Middle East conflict. He noted, “No clear secondary effects have been observed yet, but monetary policy must ensure inflation expectations remain stable.”

Just a few weeks ago, with oil prices falling, the market had all but ruled out an ECB rate hike in July. Now, rising geopolitical risks have pushed energy prices up again, filling next week’s policy meeting with uncertainty.

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