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The European Central Bank (ECB) on Thursday raised its benchmark interest rate for the first time since 2023, citing inflationary pressures stemming from the Middle East conflict, despite concerns that higher borrowing costs could further weaken the eurozone economy.
The ECB raised its deposit rate by 0.25 percentage points to 2.25 per cent, becoming the first major central bank to tighten monetary policy in response to the energy shock triggered by the conflict.
Inflation across the eurozone has risen since the outbreak of the US-Israeli war against Iran, reaching 3.2 per cent in May, above the ECB’s target of two per cent.
Announcing the decision, the ECB said, “the war in the Middle East is generating inflation pressures”.
“The outlook remains uncertain, with upside risks for inflation and downside risks for economic growth,” the Bank said in a statement.
“The full implications of the war for medium-term inflation and growth will depend on the intensity and duration of the energy price shock, as well as the scale of its indirect” effects, it added.
The ECB also revised its inflation forecast for this year upwards to three per cent from 2.6 per cent in March. At the same time, it lowered its eurozone growth forecast for 2026 to 0.8 per cent from 0.9 per cent.
The Strait of Hormuz, a vital route for global oil and gas shipments, remains largely closed. Meanwhile, a ceasefire in the three-month conflict faces increasing strain following fresh US strikes and retaliatory attacks by Tehran across the region.
First Mover
While several smaller central banks have already increased interest rates in response to the energy shock, major institutions such as the US Federal Reserve and Bank of England have so far maintained their current rates while assessing the economic impact. Both the Federal Reserve and the Bank of England are scheduled to meet next week.
For the Frankfurt-based ECB, this marks its first rate increase since September 2023, when policymakers were tackling soaring inflation caused by Russia’s invasion of Ukraine.
After that period, the ECB implemented a series of rate cuts as inflation eased but kept rates unchanged from June last year until now. Higher borrowing costs typically reduce demand, helping to curb inflation. However, a growing number of economists have criticised the latest move.
They argue that raising rates may have limited effect because current inflation stems largely from constrained energy supplies rather than excessive consumer spending.
Growth Concerns
The increase in borrowing costs is expected to place additional pressure on the 21-member eurozone, particularly after the bloc’s economy contracted in the first quarter, largely due to a downturn in Ireland. The decision also comes as households and businesses continue to grapple with high energy prices.
Analysts suggest ECB policymakers may fear repeating past mistakes after criticism for reacting too slowly to the 2022 inflation surge.
However, many economists note that current conditions differ significantly from those seen during the Ukraine crisis. Inflation had already been rising before that conflict, while the global economy was also struggling with post-pandemic supply chain disruptions.
Investors are expected to closely monitor comments from Christine Lagarde for indications of the ECB’s next steps, although analysts believe she is unlikely to provide detailed guidance.
Most market observers do not expect Thursday’s increase to signal the beginning of an aggressive cycle of interest rate hikes.
