European Central Bank Set to Raise Rates Thursday With Inflation Driven Almost Entirely by Energy

The European Central Bank meets on Thursday, and investors treat another rate increase as settled. Markets price a 25 basis point move to a 2.5% deposit rate at close to full probability, Euronews reported. The reasoning behind that certainty is more awkward than the pricing suggests, because euro-area inflation is being driven almost entirely by energy costs while underlying price pressures remain contained.

The ECB raised its deposit rate to 2.25% in June, ending a three-year pause, and held in July. Christine Lagarde, the ECB president, has argued that renewed hostilities in the Middle East and the rebound in oil prices push the inflation outlook higher, as CNBC reported in July.

That is the difficulty in plain terms. A central bank raising the price of credit cannot add supply to a market where the shortage is physical. What tightening does reach is the interest-sensitive part of the euro-area economy, meaning construction, small-firm borrowing and the refinancing costs of the more indebted member states. The council's stated case rests on preventing energy costs from moving into wages and services prices, an argument that grows weaker the longer core inflation stays quiet.

Higher policy rates also raise the cost of carrying the debt that a decade of cheap credit encouraged, which is the mechanism that turns an energy shock into a credit event rather than a price event.