Deutsche Bank: There is still a case for further ECB tightening

Overview

This report discusses whether the ECB should continue tightening monetary policy after its June rate hike. Deutsche Bank feeds the ECB's June staff forecasts into a range of simple policy rules, including Taylor rules, balance-method rules, forward-looking rules, first-difference rules, and inertia rules, to assess the reasonable path for policy rates in 2026-2027. The core conclusion is that the ECB's own inflation and growth outlook still supports further hikes, especially when the impact of energy prices is stripped out, bringing the rule results closer to market pricing and economist expectations.

Core views

The report argues that the June 25bp hike was well justified. In the base case, the policy-rule median using HICP excluding energy supports a rise in rates to about 2.75% by end-2026, equivalent to two more hikes; in the mild scenario, the rules still support a rise to about 2.50%, equivalent to one more hike. The report maintains its own base-case view of one more hike to 2.50%, but acknowledges that the tone of the ECB press conference is consistent with the risk of two hikes and a terminal rate of 2.75%.

Analysis framework

The analysis starts from the ECB's June staff forecast and plugs variables such as inflation, unemployment, output gap, long-run neutral rate, and long-run unemployment rate into a set of common policy rules. The report compares rule outcomes using headline HICP versus HICP excluding energy, and examines how policy-rate prescriptions change under base, mild, adverse, and severe scenarios. It also reviews deviations between actual ESTR and rule-implied paths during the pandemic and energy shock in 2021-2022, as well as during the 2024 easing cycle.

Methodology notes

• Monetary policy rulesTaylor rule

  Provides a nominal policy-rate recommendation based on inflation gaps and economic slack.

  The report uses the Taylor 1993 rule and its output-gap variant to test how policy rates should adjust when inflation is above target, unemployment is below its long-run level, or the output gap is positive.

• Monetary policy rulesBalance-method rule

  Places greater weight on the unemployment gap than the Taylor rule does.

  Although this rule comes from the Federal Reserve's monitoring framework, the report argues that the unemployment gap contains information about future inflation pressure and can therefore serve as a reference for ECB policy assessment.

• Monetary policy rulesForward-looking rule and core inflation rule

  Replaces current headline inflation with future inflation or core inflation to filter out short-term energy-price volatility.

  The report argues that headline HICP rules during energy-supply shocks can generate overly aggressive hike signals, so excluding energy or using forward-looking inflation better captures the second-round effects that the ECB focuses on.

• Scenario analysisECB base, mild, adverse, and severe scenarios

  Compares policy-rate prescriptions under different energy and macro assumptions.

  The report reruns the policy rules to test whether the ECB's June hike is robust across scenarios, while also noting that the alternative scenarios do not provide unemployment forecasts, limiting the set of rules that can be used to those relying on output gaps.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• Eurozone short-end rates

  Directly affected by the ECB policy path

  Strengths

  The rule results support at least one, and possibly two, additional hikes, providing a case for short-end rates to rise or remain elevated.

  Weaknesses

  If energy prices keep falling and inflation expectations ease, the 2.75% path may prove too hawkish.

  Comparison

  Rule results using HICP excluding energy are closer to market pricing and economist expectations than those based on headline HICP.

  Risks

  A rapid cooling in inflation data, a marked weakening in growth, or a more dovish ECB communication stance.

• Energy prices

  Influence policy-rule outputs through HICP and inflation expectations

  Strengths

  The decline in spot oil and gas prices and near-dated futures after the US-Iran MOU makes the mild scenario more relevant.

  Weaknesses

  Longer-dated energy futures remain closer to the base case, so the energy shock has not fully disappeared.

  Comparison

  Headline HICP rules would signal more aggressive hikes because of the energy shock, whereas rules excluding energy imply a milder policy prescription.

  Risks

  A renewed rise in oil and gas prices would push up the inflation path and increase the case for hikes under adverse or severe scenarios.

• Eurozone fixed income

  Influenced by the terminal rate, easing expectations, and inflation risk premia

  Strengths

  Policy rules provide a theoretical anchor for keeping rates high for longer, which may support the front end of the yield curve.

  Weaknesses

  The rules do not endogenously capture feedback from hikes to growth and inflation, and may overstate how high rates need to go.

  Comparison

  During the 2024 easing cycle, ESTR was broadly in the middle of the rule-implied range before gradually moving toward the lower end.

  Risks

  Actual policy may diverge from simple rules because of financial stability concerns, downside growth shocks, or fiscal policy changes.

Key data

• June hike size25bpLagarde said the hike was robust but not forceful.
• Base-case rule medianAbout 2.75%Using HICP excluding energy, this roughly corresponds to two more hikes by end-2026.
• Mild-case rule medianAbout 2.50%Roughly equivalent to one more hike this year.
• Impact of March-to-June forecast revisions25bp-50bpChanges in inflation and activity forecasts pushed the rule-implied policy path higher on average.
• Change in market pricingAn additional hike of about 25bpBetween March and June, markets priced in one more hike this year, broadly within the rule-based range.

Impact & implications

The implication for the rates market is that ECB policy risk remains tilted toward tightening, so keeping some tightening risk premium in market pricing is reasonable. If the energy-price path moves closer to the mild scenario, a 2.50% terminal rate becomes easier to justify; if adverse or severe scenarios remain plausible, pressure for further tightening in 2027 would rise again. For macro assets, short-end euro rates and policy expectations still need to focus on inflation broadening, energy prices, and marginal shifts in ECB communication.

Risks

• Policy rules are only a benchmark and cannot capture all real-time information, judgment factors, or policy tools.
• The ECB's alternative scenarios do not provide unemployment forecasts, limiting the applicability of some rules in scenario analysis.
• The inflation and GDP paths used in the rules are based on fixed market pricing and policy assumptions and do not endogenously reflect how policy changes feed back into macro variables.
• Energy prices, geopolitics, and second-round inflation effects may cause the actual policy path to diverge from the current base-case view.
• If growth is materially weaker than expected, the case for further hikes will diminish.

What to watch

• Whether the ECB's subsequent meeting language continues to signal the risk of one or two more hikes.
• Whether HICP excluding energy, core inflation, and inflation expectations continue to decline.
• Whether spot and futures oil and gas prices continue to track the mild scenario or move back toward the adverse scenario.
• Changes in market pricing for terminal rates of 2.50% versus 2.75%.
• Whether 2027 inflation and growth forecast revisions continue to support a higher policy rate.