ECB Tightening Overestimated, Capital Economics Warns

Capital Economics analysts have warned that investors are overestimating the European Central Bank's (ECB) tightening measures. They argue that a brief surge in inflation, driven by high energy costs, is unlikely to lead to sustainable wage growth, which would justify maintaining elevated borrowing costs.

The research firm expects only one more interest rate hike from the ECB this December, bringing the deposit rate to 2.75% from 2.5%. However, they believe there's little justification for further policy tightening after that.

Capital Economics predicts that the deposit rate will drop to 2% by 2028, a projection that contradicts market expectations. They also anticipate minimal secondary effects on inflation through wages and profits due to a relatively loose jobs market and adequate supply-demand balance.

In terms of inflation, Capital Economics forecasts euro zone headline inflation to reach around 4% in December before declining sharply across 2027. Core inflation is expected to rise to approximately 3% during the first half of next year as high energy costs continue to impact prices, before moderating to 2% by 2028.

While an unexpected interruption to energy supplies could drive up inflation and force the ECB to maintain high interest rates for longer, Capital Economics notes that diminished demand and a looser jobs market would still contain secondary inflation effects, making further tightening unlikely.