The European Central Bank's policymakers are confronting a complex dilemma. On one hand, raising interest rates to curb inflationary pressures risks pushing the fragile eurozone economy into recession. On the other hand, they may not need to act directly to achieve the desired policy effect, as market forces are already applying a tightening brake.

Goldman Sachs European economist Alexander Stott noted that market expectations for future monetary policy tightening, i.e., interest rate hikes, have already led to more stringent financial and lending conditions. In an analysis report released Wednesday, he wrote, "The transmission of tightening policy is already underway."

Stott highlighted, "The tightening of bank credit standards is particularly significant and is likely to intensify further. This is especially important in the eurozone, where loans account for over half of all corporate financing." He added that the current challenge lies in assessing how much of this restrictive impact is being transmitted to the real economy.

He explained, "On one hand, a large portion of the current restrictive impact is attributed to expectations of higher policy rates. Therefore, if the Governing Council aims to suppress demand and combat inflationary pressures, it must at least deliver on some of the anticipated rate hikes. On the other hand, about a quarter of the economic headwinds appear to stem from exogenous factors beyond monetary policy expectations, which reduces the necessity for aggressive tightening. All else being equal, this supports a cautious approach to raising rates, consistent with our forecast of 25 basis point hikes in June and September."

Market expectations currently indicate a high probability (around 91%) of a 25 basis point rate hike at the ECB's next meeting on June 11, which would raise the key deposit facility rate to 2.25%. A further 50% chance is priced in for another hike later in the year, in September. The likelihood of rate hikes has increased as eurozone inflation surged to 3% year-on-year by April, driven by soaring consumer prices due to the war in Iran. The next inflation data release is scheduled for June 2.

ECB policymakers have reiterated President Christine Lagarde's stance, emphasizing a data-dependent, meeting-by-meeting approach to monetary policy. ECB Vice President Luis de Guindos told media on Wednesday that central banks must balance the need to quell inflation with avoiding excessive pressure on economic output. De Guindos stated, "I believe there is no predetermined path for the evolution of interest rates. The discussion will be open, with all factors balanced and taken into consideration."

Similarly, François Villeroy de Galhau, Governor of the Bank of France and a member of the ECB Governing Council, told media earlier this week that European policymakers "will take the necessary measures" to bring inflation back to the 2% target.

The ECB's credibility is under scrutiny. Economists are divided over whether the ECB should raise rates, given the eurozone's weak economic growth. Latest data shows the eurozone economy grew by only 0.1% in the first quarter.

Holger Schmieding, Chief Economist at Berenberg Bank, stated last week that Europe's "big three" economies—Germany, France, and Italy—have been weakened by the recent surge in energy costs, leading to a stagflationary environment characterized by rising inflation and unemployment alongside slowing growth. Schmieding argued that demand destruction should "automatically resolve" the inflationary part of the stagflation dilemma, as consumers cut spending on other goods to cover higher energy costs—thereby eliminating the need for aggressive tightening. "It is important to distinguish between what the central bank might unfortunately do and what is the right thing to do," Schmieding said last week, adding, "My impression is that the European Central Bank will make a major mistake."

In an analysis report on Thursday, Filippo Alloatti, Head of Financials Credit at Federated Hermes, stated that the ECB is in a difficult position. He noted, "The economic impact of disruptions to energy infrastructure in the Middle East is severe and highly uncertain. Even if tensions ease, oil prices are likely to remain structurally elevated," pointing out that countries like Germany and Italy are particularly vulnerable to sustained energy cost shocks. "At the same time, the ECB is dealing with the legacy of earlier policy errors, having kept rates too low for too long after the pandemic," he added. "Consequently, the central bank is under increasing pressure to respond decisively to inflation pressures and second-round effects. Anchoring inflation expectations has become crucial, suggesting the need for... a 25 basis point hike as early as June."

Alloatti concluded that, ultimately, the bank's credibility is being tested. "Any hesitation risks undermining confidence in its ability to maintain price stability—confidence that, once lost, is difficult to regain. In a globally uncertain environment, the ECB needs to balance growth risks against inflation pressures while reinforcing its commitment to financial and monetary stability."