2026-09-11 Friday

The euro area has absorbed the Middle East conflict better than the ECB expected in June, and the September staff projections keep the recovery intact: real GDP growth of 0.9% in 2026, 1.4% in 2027 and 1.5% in 2028. The inflation path is less comfortable.

The energy assumptions carry the revision. Oil is assumed to average $88/barrel in the third quarter of 2026, but gas prices have been revised up by 20% and electricity prices by 50% relative to the June projections, and the euro has depreciated since then. That mix — cheaper oil, dearer gas and power — is what lifts the 2026 inflation peak while leaving the growth path broadly intact. The baseline also embeds temporary energy support measures worth a negligible share of GDP, and the staff complement it with milder, adverse and severe scenarios that differ in energy price paths and indirect effects; the conflict, the Strait of Hormuz blockade and energy volatility are named as the dominant uncertainties.

The fiscal arithmetic is where the projections bite for bond markets. Interest payments add a small fraction of a percentage point of GDP in 2026 and a larger amount over 2027-28, while market expectations for short-term rates have been revised up by a similar modest margin for 2027 and by more for 2028. The mechanism is straightforward: a wider deficit and a heavier debt stock raise government bond supply into a market that is simultaneously pricing higher policy rates, so the sovereign curve absorbs both more duration and a higher risk-free anchor. The unemployment rate declines over the horizon to 5.9%, which supports the revenue side but does not offset the spending impulse. Against the June round, the technical assumptions now combine lower oil and farm gate prices with higher gas and electricity prices, a weaker euro, broadly unchanged interest rates and higher equity prices — a combination that flatters activity while worsening the near-term inflation trade-off.

The ECB raised its three key interest rates by 25bp on 10 September 2026, with the Governing Council pointing to a Middle East energy shock that keeps headline inflation well above its target. The decision is framed as data-dependent and meeting-by-meeting, with no pre-commitment to a particular rate path.

The inflation picture is driven by energy: energy price inflation rose to 14.3% in August, while food price inflation was unchanged at 1.2% and inflation excluding energy and food edged down to 2.4%. Services inflation fell to 3% and goods inflation rose to 1.2%. Headline inflation reached 3.3% in August, up from a lower reading in July. Staff projections put headline inflation at 3% in 2026, 2.5% in 2027 and 2.1% in 2028, with the energy shock assumed to keep inflation above target into the first half of 2027 before energy inflation declines and turns negative up to mid-2028.

Growth remains weak: the baseline projection is 0.9% for 2026, 1.4% for 2027 and broadly unchanged in 2028, with the unemployment rate unchanged at 6.4% in July. Underlying inflation pressures are mixed: compensation per employee grew at 3.3% in the second quarter, unit labour costs slowed to 2.6%, but unit profit growth rose to 2.2%. The ECB wage tracker points to negotiated wage growth of 2.7% in the first half of 2027. Transmission is visible in lending conditions: bank lending rates for firms stood at 3.8% in June and July, and the cost of market-based corporate debt was 4% in July.

Risks to inflation are to the upside from a further intensification of the energy shock, stronger second-round effects, gas price increases, renewed trade tensions and extreme weather events; risks to growth are to the downside from the Middle East conflict, Russia's war against Ukraine, potential energy supply disruptions, worsening global financial market sentiment and resurgent trade tensions. The neutral rate is described as highly conceptual and not given great importance in current circumstances. The rate hike raises the cost of bank lending to firms and market-based corporate debt, tightening credit conditions further as the ECB continues to reduce its balance sheet.

The ECB Governing Council raised its three key policy rates by 25bp on 10 September 2026, the second increase of the year, and the staff projections published with the decision show headline inflation at 3% in 2026, 2.5% in 2027 and 2.1% in 2028. The move is a direct response to an energy-driven inflation shock: headline inflation rose further to 3.3% in August, and energy inflation jumped to 14.3% from double-digit rates in July. The Council's baseline assumes inflation stays well above its target into the first half of 2027 and returns to around target only towards the end of that year.

The composition of the August print matters for the policy path. Core inflation, excluding energy and food, eased slightly to 2.4% from a higher July reading, and services inflation fell to 3% from a faster pace, while goods inflation rose to 1.2% from a near-zero reading. Food inflation was unchanged at 1.2%. The projections embed a core rate of 2.5% for 2026, and the growth outlook is subdued: GDP growth of 0.9% in 2026 and broadly unchanged over the following two years. The unemployment rate held at 6.4% in July.

The wage and cost data give the Council room to look through the energy spike. Compensation per employee grew 3.3% year on year in the second quarter, down from the prior quarter's pace, and unit labour cost growth slowed to 2.6% from the same prior-quarter pace. Unit profit growth rose to 2.2% from a marginal prior pace, and the ECB Wage Tracker points to negotiated wages of 2.7% in the first half of 2027. The transmission channel is already visible in bank lending rates to firms, which stood at 3.8% in July, up from the May reading.

The Council names spillovers to global bond markets and tighter credit conditions as a downside risk to demand, alongside renewed energy supply disruptions, trade tensions and a cold winter with low gas storage. Upside risks to inflation dominate the risk assessment, with growth risks skewed to the downside. The mechanism for markets is straightforward: with the policy rate now higher and lending rates to firms already at 3.8%, the Council is explicitly relying on tighter credit conditions to dampen demand and bring inflation back to target, while the energy shock keeps the headline rate above target into 2027.

ESMA's second risk monitoring report of 2026 finds EU markets resilient but warns that stretched technology valuations and heightened geopolitical tensions are testing that resilience, with the disconnect between deteriorating macro-financial conditions and upbeat valuations raising the risk of sudden corrections. Equity markets have rebounded to or above pre-Middle East conflict levels even as sovereign yields rose and spreads widened on funding and safe-haven concerns — the same widening that raises the cost of new issuance for EU sovereigns and turns a valuation-led equity correction into a duration problem for bondholders.

The five largest big tech companies are set to spend $1trn on AI-related capital expenditure across 2025 and 2026, with global AI-related investment projected to climb from $500bn today to $3trn by 2030, according to a BIS speech at an RBI fintech gathering in India. The same concentration that drives the boom is the stability concern: in Korea, five firms accounted for 43% of export earnings in the first quarter, up from just over a quarter two years earlier, and the largest listed AI firms now represent a substantial share of stock market capitalisation, capex and revenues in their home economies. For central banks, the BIS argues, AI makes the economy harder to read — raising uncertainty around r-star and potential output — while the debt and private credit financing behind the build-out leaves an investment bust with global spillovers as a live risk.

HM Treasury published its response to the consultation on a Visitor Levy in England, confirming that Mayoral Strategic Authorities will be able to create local overnight visitor levies; the document also settles whether Foundation Strategic Authorities get the same power, and covers revenue use, the scope of accommodation, rate-setting, liability and administration. The fiscal channel runs through the mayors' own budgets: a levy on overnight stays is a revenue line that sits with the combined authority rather than Westminster, so the borrowing capacity behind it depends on how the rate is set and who is liable. The design decisions are buried in a consultation-response document rather than in a fiscal event, and the next step the response itself sets out is the legislation and the individual mayoral decisions that follow; the test is whether any mayoral authority publishes a draft scheme with a rate and a start date.

OFAC is indefinitely suspending three general licenses and one licensing policy under the Iranian Transactions and Sanctions Regulations, effective September 8, 2026, and has stayed its Iran general license of December 15, 2016, which had permitted reexportation of civil aircraft to Iran on temporary sojourn. The suspended provisions had authorised certain payments for overflights of Iranian airspace and specific licences for related transactions. OFAC's stated grounds are Iran's continued disruptions to global energy markets, attacks on partners and allies in the Middle East, and reconstitution of its capabilities. The channel to price of money is the airspace: carriers that had paid for overflight rights now face rerouting, and the licence withdrawal lands in the same energy-market disruption OFAC cites, so the cost shows up in fuel and freight rather than in a sanctions headline. The action sits in the Federal Register notice rather than in a Treasury press release, and the UK's own Iran sanctions amendments effective 29 September 2026 — flagged in our earlier briefings — are the parallel track to watch; what would settle the divergence is whether London aligns its overflight and aviation provisions with the US suspension or leaves them in place.

The Czech National Bank's Bank Board left the countercyclical capital buffer rate at 1.5%, judging it sufficient to cover banking-sector risks from the economy's position in the expansionary phase of the financial cycle. The CNB said the Czech economy moved further into that expansionary phase in the first half of 2026, with household credit activity remaining high partly because households borrowed ahead of tighter investment-mortgage conditions and expected rate rises, while corporate investment lending strengthened. The buffer is the lever that prices mortgage and corporate credit through bank capital: holding it at 1.5% while lending accelerates means the constraint on balance-sheet growth comes from the rate path rather than from capital requirements, and the CNB itself flagged considerable uncertainty over whether strong credit growth persists. The judgement is in the Bank Board's buffer decision rather than in the monetary policy statement, and the next scheduled Bank Board buffer review is what would settle it — a move in the rate, or a CNB statement that credit growth has stopped being the reason for the current setting, would be the trigger.