The European Central Bank may pause rate hikes next week, and market expectations for rate hikes have focused on the September meeting.

The ongoing Middle East conflict continues to stir the energy market, casting a shadow over inflation prospects, and setting a new round of challenges for the European Central Bank’s policy trajectory.

The European Central Bank will announce its interest rate decision on July 23. Although the market generally expects this meeting to keep the benchmark interest rate unchanged at 2.25%, the recent rise in oil prices and renewed inflation risks have significantly heightened bets on another rate hike in September, and discussions within the ECB about further tightening are expected to become more active.

Inflation in the eurozone fell more than expected in June, and oil prices had retreated notably from their conflict-induced highs, giving policymakers a brief window to observe. However, the recent escalation in Middle East conflict has driven a rebound in energy prices, tighter fertilizer supply from the Middle East, and Europe's heatwave may push up food prices, all reshaping inflation prospects and complicating the ECB’s policy path for the coming months.

Likely to hold steady in July, September signaling may be the focus

The market generally expects the ECB to keep rates unchanged at the July meeting.

The ECB was the first major central bank to start raising rates in June in response to inflation risks from the Middle East conflict. Energy prices subsequently fell, alleviating policy urgency somewhat; but recently, Brent crude has returned to around $85 per barrel, reigniting concerns about rising inflationary pressure.

According to reports, Morgan Stanley’s Chief European Economist Jens Eisenschmidt said: "Someone will definitely raise the question of a rate hike at the meeting, and I am quite sure a few policymakers will discuss this option." He believes that, even if rates remain unchanged, the discussion itself could be an important way the ECB signals policy direction for September.

Currently, the money market still prices in a modest probability for a rate hike in July, reflecting investors’ cautious outlook on policy prospects.

Most economists bet on a September rate hike, market starts trading a second action this year

Reuters surveyed 74 economists, and the overwhelming majority expect the ECB to raise rates again in September and update its economic forecasts.

According to Reuters, even when oil prices previously fell, there were still reasons within the ECB supporting further rate hikes. With energy prices rising again, the market is even starting to bet on another hike later in the year after September.

However, economists are distinctly more cautious. Out of 74 respondents, only 3 expect the ECB will implement a second rate hike this year, indicating that market pricing has moved well ahead of mainstream forecasts.

Ross Hutchison, Eurozone Market Strategy Lead at Zurich Insurance Group, said: "From the recent statements of most ECB officials, it is clear they are more worried about once again underestimating inflation risks than economic growth slowing."

Some institutions believe the ECB still has patience to wait for more data. Bas van Gaffen, Senior Macro Strategist at Rabobank, said there has not yet been a noticeable acceleration in wage growth or secondary inflation effects, so policymakers "can fully wait until September to assess the actual impact of the Middle East situation on inflation."

Minimum reserve requirements may be raised, liquidity continues to tighten gradually

Beyond interest rate policy, the ECB may further adjust its liquidity framework.

According to Reuters, the ECB is considering doubling the minimum reserve requirement that banks must deposit in non-interestbearing accounts, to reduce the cost incurred by paying interest on excess reserves. With interest rates remaining high, this expense continues to rise.

The market sees this move as more liquidity management than a new tightening tool. Societe Generale estimates this would reduce eurozone banks’ excess liquidity by about 160-170 billion euros, while the ECB’s quantitative tightening annually has withdrawn about 500 billion euros liquidity. Thus,overall impact is relatively limited, but signals ongoing liquidity tightening.

Digital euro advances, payment autonomy becomes strategic focus

The digital euro project is also accelerating. According to Reuters, the ECB in June gained key support from the European Parliament, ending a three-year standoff with the banking industry, which had been concerned the digital euro may cause deposit flight and impact profitability.

Meanwhile, tariff policies from the Trump administration have raised European concerns about further politicization of the dollar payment system, making the strategic importance of enhancing Europe’s payment system autonomy more prominent. As currently planned, the EU is expected to complete digital euro legislation by the end of this year, begin pilot testing in 2027, and officially launch in 2029.

Morgan Stanley’s Eisenschmidt believes the digital euro will help reduce Europe’s reliance on foreign payment networks, but since the current scheme mainly targets retail payments, its role in achieving this strategic goal remains somewhat limited.

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