ECB Rate Hike Sets the Bar for the Fed and Bank of England

The ECB has effectively set a benchmark against which the Federal Reserve and Bank of England will now be judged at their meetings next week. That could prove particularly important for the euro's performance against the dollar and sterling over the weeks ahead. If other central banks are perceived as being less willing to respond to renewed inflationary pressures, their currencies could come under pressure as markets reassess the relative credibility of their monetary-policy regimes.

A Deteriorating Inflation Outlook Drives the ECB's Decision

The case for another rate hike had strengthened considerably in recent weeks. The eurozone economy has proved more resilient than previously expected, with stronger-than-expected second-quarter growth supported by government spending and tech investment. That gives the ECB somewhat more room to respond to renewed inflationary pressures without exacerbating an already weak growth outlook.

More importantly, the inflation outlook has deteriorated sharply as the conflict in the Middle East has dragged on. Oil prices have risen back above $100 a barrel, while European natural gas prices have also surged. With winter approaching and gas storage levels well short of where they would normally be at this point in the year, the eurozone is particularly exposed to the energy shock, raising the prospect that elevated costs could feed through into broader prices.

The ECB now expects inflation to average 2.5% in 2027, up from its previous forecast of 2.3%, and does not expect inflation to return sustainably to its 2% target until 2028.

That leaves policymakers facing an awkward trade-off. Higher interest rates cannot bring down the price of oil or natural gas, but the ECB can attempt to prevent the energy shock from becoming embedded in wages, services and inflation expectations. Today's hike therefore looks as much like an insurance policy against second-round effects as a response to inflation already visible in the data.

ECB President Christine Lagarde nevertheless stopped short of committing to further increases, stressing that future decisions will remain data-dependent. Markets, however, are already pricing the possibility of at least one further hike this year.

The FX Test: What the ECB Rate Hike Means for the Dollar and Pound

For currency markets, this is where today's decision becomes particularly interesting. The euro's reaction to the announcement was muted, as the rate increase had already been anticipated, with much of the adjustment having taken place before the meeting. The more important question is what today's ECB rate hike means for the relative policy stance of the world's three major central banks.

The Federal Reserve meets on September 16. Fed Chair Kevin Warsh's recent Jackson Hole speech sought to reinforce the Fed's commitment to its inflation target. If that rhetoric is not followed by sufficiently forceful action as inflationary pressures build, markets could seriously question the Fed's resolve — and its ability to withstand political pressure.

That would create a potentially uncomfortable environment for the dollar. The US economy may be better placed than the eurozone to absorb higher energy prices, but that does not insulate the Fed from the inflationary consequences of the shock. With producer prices already showing renewed pressure and markets increasingly pricing further tightening, the ECB's decision has only heightened the scrutiny facing the Fed.

Sterling faces a similar test. The Bank of England has so far taken a cautious approach, holding rates at 3.75% in July despite three MPC members voting for an increase to 4%. The Bank has acknowledged that higher energy prices are likely to push UK inflation higher later this year, while stressing that monetary policy cannot directly influence the underlying energy shock.

That makes the UK's September 17 meeting particularly important. Market pricing suggests the decision on monetary tightening is more finely balanced than at either of the other major central banks. A hike would bring the Bank of England closer to the ECB's more forceful response to renewed inflationary pressures and could support sterling. A hold, by contrast, risks leaving the pound vulnerable if markets conclude that the Bank is falling behind its counterparts in confronting the inflation threat.

Currencies Will Judge Central Bank Resolve

The ECB has made the first move. For the euro itself, today's decision may have limited immediate impact. But its significance for the dollar and sterling will depend on how the Fed and Bank of England respond. With energy prices high, inflation above target and government bond markets showing signs of unease over the sustainability of public finances, investors are becoming increasingly sensitive to whether policymakers appear willing and able to confront inflation rather than accommodate it.

That creates an asymmetric risk for the major currencies. Central banks that demonstrate a credible willingness to protect their inflation targets could find their currencies supported, even if tighter monetary policy weighs on domestic growth. Those perceived as falling behind the curve could face depreciation as investors demand greater compensation for holding their assets.

The ECB has moved first. The question for the euro, dollar and pound now is whether the Fed and Bank of England are prepared to match it.

Key Takeaways

• The ECB has raised its deposit rate to 2.5%, citing persistent inflation driven by rising energy prices and the ongoing US-Iran conflict.

• The ECB now does not expect inflation to return sustainably to its 2% target until 2028 — a significant shift that reinforces the case for further tightening.

• The Fed (September 16) and Bank of England (September 17) now face a credibility test: match the ECB's resolve or risk currency weakness.

• Sterling is particularly exposed — the BoE's decision is more finely balanced than either the Fed's or ECB's, making it the highest-risk meeting for currency markets this week.

This article is for informational purposes only and does not constitute financial advice. This commentary reflects Bondford's views and should not be construed as representing the views of the author's employer or any other affiliated organisation.