By Francesco Canepa and Balazs Koranyi
SINTRA, Portugal, June 30 (Reuters) - The unexpectedly rapid retreat in energy prices in the past week has further taken pressure off European Central Bank policymakers to lift interest rates next month but the case for a small hike later on remains firm, four sources told Reuters.
The ECB lifted interest rates this month to prevent an Iran-war induced oil-price spike from raising price expectations, and policymakers are now debating the urgency of any follow-up
move.
The sources, all with direct knowledge of the discussion, said they were surprised by how quickly oil prices have eased and futures for several key durations were now even below the bank's 'milder' scenario.
Fear of shortages for items such as jet fuel have been proven wrong while some producers, particularly Saudi Arabia, have increased energy output more than forecast to keep the market supplied.
China also consumed less oil than predicted, likely because it substituted oil with other energy sources more aggressively than expected. That further supports the case for a rapid retreat in energy prices once supplies normalise, the sources said.
An ECB spokesperson declined to comment.
Oil prices did not even react strongly to the escalation of the conflict between Iran and the U.S. over the weekend, suggesting that normalisation of the energy market was well underway, the sources added.
SEPTEMBER HIKE STILL MOST LIKELY
A rate hike in September remains the more likely scenario for now, but the sources said June inflation data due on Wednesday, still carried greater significance.
If the headline figure indeed retreats from 3.2% as financial markets now anticipate, then waiting until September was the better option, one of the sources said.
However, a negative surprise would strengthen the case for a quick follow-up hike in July, the source added.
Retreating consumer and business price expectations also back the case for taking some time before pulling the trigger again.
The ECB targets inflation at 2%. Its baseline projection does not see it back at that target until the second half of next year. Its milder scenario sees it well below 2% by mid-2027.
Financial markets now see just a one-in-three chance of a rate hike in July, and are not fully pricing in a hike until October.
This follow-up hike, already advocated by some, is likely to prevent the oil surge from seeping into the broader economy, setting off a second-round effect that could worsen inflation.
The sources, however, agreed that such second-round effects have been negligible for now, even if economic logic dictates that some will eventually result.
The ECB will next meet on July 23.
(Editing by David Gaffen)
