The European Central Bank (ECB) on Thursday raised its benchmark deposit rate from 2% to 2.25%, marking its first hike in interest rates since September 2023 as the Frankfurt-based bank outlined its response to the economic fallout from the conflict in Iran.
"The war in the Middle East is generating inflation pressures," said ECB head Christine Lagarde, warning that "the outlook remains uncertain."
The ECB previously left the interest rate paid to commercial banks on funds parked with the ECB at 2% for seven consecutive meetings, but the conflict in the Middle East has fuelled fears of a wave of inflation due to the blockade of the Strait of Hormuz, a crucial waterway for the global oil and gas trade.
The United States and Iran have been negotiating for months over a solution to the conflict, but the ceasefire appears to be at risk after both sides traded fresh strikes for two consecutive nights.
A further escalation could significantly impact the eurozone economy, which has already seen inflation soar and growth forecasts revised down.
"Prolonged disruption of energy supplies could increase energy prices further and for longer than currently expected," Lagarde said in her risk assessment, explaining that a fall in consumer spending and further "frictions in international trade" could impact growth.
The ECB forecasts inflation to rise to 3% across the eurozone in 2026, before settling at 2.3% in 2027 and hitting the bank's 2% target in 2028.
Higher interest rates make borrowing more expensive for consumers and businesses, which can curb demand and thus help to lower inflation.
Savers benefit when banks pass on rising base rates. At the same time, interest rate rises are a burden on an economy that is already struggling.
The ECB is in a quandary: if it raises interest rates too sharply, it runs the risk of stifling the economy.
“Given that inflation in the eurozone is above 3% and there is little hope of a de-escalation in the Iran conflict, raising interest rates is the right move at this stage,” said Clemens Fuest, president of the Munich-based ifo Institute.
Some economists expect that the hike will not be the only one this year, with Lagarde having repeatedly emphasized the central bank’s ability to act.
"The ECB is likely to follow up at its September meeting," said Commerzbank chief economist Jörg Krämer.
The Frankfurt-based bank is determined to prevent a new wave of price rises in the 21-member currency area.
Following the outbreak of the Russian war against Ukraine in February 2022, the ECB came under criticism for having long underestimated the rise in prices during the energy crisis.
Inflation in the eurozone soared to over 10%, with energy and food prices rising especially rapidly in Germany.
The effects of these price rises are still being felt today, as food remains around one-third more expensive than in 2019.
