ECB set to raise rates, all eyes on Lagarde's guidance

A 25 basis point rate increase is widely anticipated from the ECB this week, bringing the deposit facility rate to 2.50%. That level is approximately the top of what most central bank policymakers consider neutral. If not, it edges into mildly restrictive territory at most.

The upcoming rate increase is not a game-changer for the fight against inflation. Rather, it serves as a building block and a starting point, should the ECB need to escalate its efforts due to concerns about second-round effects later on.

Put simply, the rate hike is a positioning step.

The key aspect is gauging the ECB's willingness to adopt more restrictive measures and what might prompt policymakers to act sooner rather than later on tightening.

What do markets currently price in for this week?

A 25 basis point rate increase is already fully priced in by markets. Consequently, no surprises are expected from the ECB, nor in the market reaction.

The main focus now is on how traders will adjust their pricing based on the ECB statement and, more importantly, Lagarde's press conference. The statement is not expected to hold back on its language. Thus, the press conference will be the main event in tomorrow's decision.

The statement will probably reaffirm a data-dependent and meeting-by-meeting approach, noting that it is not the appropriate time to commit to a specific rate path in advance.

Therefore, the burden will be on Lagarde to convey the ECB's intentions and next steps, and whether they see a need to act earlier or later than markets anticipate.

Currently, traders are pricing in approximately 47 basis points of rate hikes by the end of this year, including this week's increase. By June next year, around 80 basis points of additional hikes are priced in.

Lagarde's press conference takes center stage.

The tone of the press conference will be closely examined, as markets seek to gauge the ECB's readiness to tighten policy further in the coming months.

However, barring a significant shift in the macroeconomic projections—which appears unlikely—Lagarde will have leeway to maintain a measured tone in her communication.

An upward revision to near-term growth forecasts would enable her to depict a more resilient euro area economy, thereby giving her flexibility to connect that with the latest inflation data and forecasts.

Lagarde is also expected to reaffirm a data-dependent and meeting-by-meeting stance, but it will be notable if she reiterates that the ECB's reaction function is 'well understood' by markets. If she does, that would imply some endorsement of current market pricing for the central bank's future moves.

Additionally, her remarks will be monitored for any hints about the policy direction given the current rate hike profile priced in by markets.

Market reaction expectations

Since a 25 basis point hike is already fully priced in, the rate decision alone will provide no new information for traders.

Rather, the actual market response will depend almost solely on how Lagarde frames the future path.

If Lagarde delivers a fairly neutral press conference, sticking closely to the ECB's data-dependent and meeting-by-meeting language, the euro and European bond markets may have little incentive to move substantially. Such communication would implicitly confirm the current market pricing for the ECB.

A larger reaction would only occur if Lagarde provides markets with reason to reconsider that pricing.

If she chooses to emphasize second-round inflation effects, wage pressures, or the need to push policy further into restrictive territory, that could trigger a more hawkish response in broader markets. However, with another rate hike largely priced in for December, it may be difficult for traders to push too far. Still, it could push the euro higher, exert upward pressure on European bond yields, and weigh on equities.

Conversely, Lagarde could highlight that the 2.50% deposit rate is more or less the 'sweet spot' given the economic backdrop. It places the ECB in a position where it can respond if inflation pressures become a bigger problem, while not being so restrictive as to choke the economy for now.

That could lead traders to reduce their pricing for a December rate hike, potentially weighing on the euro and pulling front-end yields lower, at least.