The ECB’s decision to raise interest rates today comes against the backdrop of downwardly revised growth forecasts and upward revisions to inflation projections across the forecast horizon.

Headline and underlying inflation is expected to remain well-above the central bank’s target during 2022-24. Risks to growth are to the downside and those to inflation are to the upside. Despite the large upward revisions, we think the 8.1% forecast for headline inflation for this year is too low and perhaps suggests that the ECB is assuming some sort of a price cap that could be announced as early as tomorrow.

The tide is shifting swiftly towards more fiscal measures to support economies from surging energy prices. A fiscal boost in the face of a tight labour market, still elevated supply chain bottlenecks and other cost-push pressures, will likely mean that underlying inflation will remain sticky in the medium-term. Central banks will be called upon to be aggressive in their rate hiking to prevent inflation expectations from becoming un-anchored. The 75bps hike from the ECB today, combined with the hawkish statement, could also set the precedent for the Bank of England.

ECB Executive Board member, Isabel Schnabel, outlined in her speech at Jackson Hole last month that monetary policy will respond forcefully to the current bout of inflation given the uncertainty about the persistence of inflation, the threats to central bank credibility from inflation expectations getting de-anchored, and the potential costs of acting late.

The ECB is also emboldened by its new anti-fragmentation tool – the Transmission Protection Instrument (TPI) – which it can deploy to counter unwarranted, disorderly market dynamics as it normalises policy. Markets are pricing in additional 150bps rate hikes by July 2023, taking the terminal rate to 225bps. The room for disappointment is large as the ECB has been behind the curve and the repercussions for the euro from any disappointment could be sizeable, potentially adding to inflationary pressures.