Are investors expecting too many hikes from the ECB?

Capital Economics analysts suggest investors may be overestimating the European Central Bank's (ECB) plans for rate hikes. The analysts argue that a temporary rise in inflation, driven by higher energy prices, is unlikely to create the sustained wage pressures necessary to maintain high interest rates. The firm anticipates the ECB to increase its deposit rate once more in December, bringing it to 2.75% from 2.5%, but does not foresee additional tightening beyond that.

Capital Economics anticipates the ECB will revert to cutting rates in the second half of 2027, with the deposit rate eventually dropping to 2% by 2028.

The research firm believes the second-round effects on inflation through wages and profits will be minimal due to the euro zone's labor market not being particularly tight and demand not outpacing supply. The firm projects euro zone headline inflation to rise to around 4% in December before sharply declining in 2027. Core inflation is expected to increase to about 3% in the first half of 2027 as higher energy costs trickle through indirectly, before easing towards 2% by 2028.

The analysts expect the ECB to maintain its current rate, maintaining its growth forecast for the euro zone economy. GDP is projected to expand by 1.0% in 2026, 1.1% in 2027 and 1.0% in 2028. Capital Economics does caution that a prolonged disturbance in energy supplies through the Strait of Hormuz could push inflation higher and compel the ECB to keep rates higher for a longer period.

However, they maintain that weaker demand and a softer labor market would limit second-round inflation effects, reducing the necessity for rigorous tightening measures.