European Central Bank is set for hawkish pause as the economy turns south 

FRANKFURT — The European Central Bank is set to keep rates steady Thursday as economic activity in the euro area decelerates at a faster pace than previously expected. 

Shoppers in the region are holding back on spending as inflation eats up their disposable income, while the manufacturing sector has been in decline since around mid-2022. 

Economic theory would suggest that these two factors would drag inflation down. But whether this will prove to be the case is a still open debate inside the walls of the Frankfurt institution. 

“While doves will argue that it is just a question of time before weaker growth feeds into lower inflation, the hawks lean on part of the weakness in growth stemming from supply rather than demand,” said Paul Hollingsworth, chief economist with BNP Paribas, in a recent research note. 

“As a result, price pressures might be less sensitive to weaker growth than would typically be expected.”

Headline inflation for August was slightly higher than expected at 5.3%. But core inflation, which excludes energy and food and is closely watched by the ECB as a gauge of underlying price pressures, fell in line with expectations to 5.3% as well, down from 5.5% the month prior.

More information on what the ECB thinks about inflation and the growth trajectory will be revealed in a new round of staff projections on Thursday. The market expects revisions both to the ECB’s GDP and inflation outlook. 

“Given the recent data, the staff are likely to revise down the near-term outlook for growth,” said Deutsche Bank’s ECB watcher Mark Wall in a research note. 

“Tighter financial conditions and slower growth should translate into a lower level of core inflation by the end of the forecast horizon.” 

The outlook is still very uncertain. That’s what President Christine Lagarde stressed at Jackson Hole last month, the Federal Reserve’s annual conference. The past few years have seen numerous shocks which have caused lasting effects on the economic system and the transmission of monetary policy. 

“We have to form a view of the future and act in a forward-looking way,” Lagarde said in her speech at Jackson Hole. “But we will only ever truly understand the effects of our decisions after the fact,” she added.