BoE and ECB hold rates steady as energy risks cloud the inflation outlook

Summary

European Central Bank

Policymakers among the governing council at the ECB were agreed unanimously in maintaining the central bank's interest rate. The market anticipated the move,  as the data that influences the decision, such as inflation and inflation expectations, have become slightly more subdued in recent weeks.

Although Eurozone price growth remained above the ECB's target of 2% for the fourth consecutive month, headline inflation eased from 3.2% in May's print to 2.8% in June. The June figure also showed that price growth decelerated for the first time since the turn of the year. The central bank has been concerned about the "second-round" effects of the recent energy price spikes due to the ongoing conflict in the Middle East, and the governing council remains on high alert to that risk. However, President Lagarde noted that these  “second-round” effects have yet to materialise, giving policymakers no immediate cause to act.

The ECB forecasts that Eurozone inflation is to remain above their target for a prolonged period. The most recent projections from the central bank expect inflation to average 2.4% in 2026 and 2.2% in 2027, reflecting their concern of a lingering impact of higher energy prices despite recent moderation.

Growth in the Euro Area improved reasonably during the second quarter, supported by resilient services activity and defence spending. However, the ECB continues to forecast only 0.8% GDP growth in 2026, with risks tilted to the downside as energy price fluctuations and geopolitical uncertainty continue to weigh on household spending, investment, and business confidence. Labour-market conditions remain strong, with unemployment close to historic lows at 6.2%.

Swap rates initially spiked by 5bps leading to year-to-date highs, although the move reversed in the week following the decision, down 10bps.

Bank of England

A 6-3 majority vote kept BoE interest rates unchanged in the central bank's July meeting. The current level has remained at 3.75% since the latest rate cut in December last year. There were three dissenting policymakers, up from two in the previous meeting, who backed an immediate rate hike amid fears that higher energy prices could trigger broader inflation pressures.

Governor Andrew Bailey maintained his cautious tone, saying "inflation has fallen faster than expected, but the conflict in the Middle East continues to mean high and volatile energy prices. That will cause inflation to rise again this year." Bailey stated that, at present, there is little evidence that higher energy prices are feeding through into wages or broader pricing behaviour.

Although headline inflation eased to 2.6% in June, the BoE expects CPI to rise to around 3.2% in Q4 2026 as higher energy costs gradually feed through to consumers.

One policymaker, Megan Greene, justified her stance on hiking this month by noting that inflation has been above the central bank's target for five years, despite price growth moderating in June. Although the committee was split on the vote, members remained unified in their belief that there is an upward skew in inflation risk due to persistent energy price volatility.

Supporting a cautious approach are weak domestic conditions, with the labour market gradually loosening. Unemployment is expected to rise above 5% by the end of the year, whilst wage growth has stabilised at a near six-year low. Economic growth continues to be sluggish as the IMF projects the UK economy to grow by just 1% in 2026. Heightened energy prices, elevated borrowing costs, and weaker confidence are weighing on demand.

In the twenty-four hours surrounding the decision, swap rates fell by 9bps.

Moving Forward

Looking ahead, markets are pricing in a 65% chance that the ECB opts for a 25-basis point hike in September, given the lack of action taken at the July meeting. However, any decision remains highly data-dependent. Future rate increases remain in play if inflation remains elevated, especially if the "second-round" effects start to appear.

Despite a moderately hawkish split vote and an increase in dissenting members voting for a hike, markets have trimmed expectations, currently pricing only a 30% chance of a BoE hike in September. Market participants have adopted a "higher for longer" outlook as the benchmark rate is expected to have a chance of hitting 4.25% in 2027.