Are investors expecting too many hikes from the ECB?

Analysts at Capital Economics believe investors might be overestimating the number of rate hikes the European Central Bank will enact. The research firm argues that a temporary rise in inflation due to surging energy prices is unlikely to result in sustained wage pressures necessary to maintain high interest rates. Capital Economics anticipates the ECB to raise its deposit rate once more in December, bringing it up to 2.75% from the current 2.5%, but sees no pressing need for additional rate hikes beyond that.

The firm expects the bank to start cutting rates in the second half of 2027, with the deposit rate eventually dipping to 2% by 2028.

Capital Economics believes the "second-round" impacts of inflation, such as wage and profit increases, are expected to be minimal. This assessment is based on the fact that the euro zone labor market remains relatively tight and demand is not outpacing supply. The economists project euro zone headline inflation to reach around 4% in December before dropping sharply in 2027.

Core inflation is forecast to rise to about 3% in the first half of next year as higher energy costs trickle through indirectly, but then ease towards 2% by 2028.

According to Capital Economics, the ECB is unlikely to tighten monetary policy much further, if at all, after raising the deposit rate in December. The firm's 2028 rate forecast is below the current market expectations. The economists also anticipate the euro zone economy will continue to grow at roughly its trend rate, with GDP projected to expand by 1.0% in 2026, 1.1% in 2027, and 1.0% in 2028.

While Capital Economics acknowledges that a prolonged energy supply disruption through the Strait of Hormuz could push inflation higher and result in the ECB keeping rates elevated for longer, they argue that weaker demand and a softer labor market would limit the second-round inflation effects. This, in turn, would reduce the need for aggressive tightening measures.