The European Central Bank raised interest rates for the first time in nearly three years on Thursday in the hope of curbing inflation before a surge in energy costs triggered by the Iran war spreads more broadly across the euro zone economy.
It was the first hike by one of the major global central banks in response to the energy shock and comes a week before the U.S. Federal Reserve, Bank of Japan, Bank of England and several other leading institutions take policy decisions.
The well-telegraphed ECB move came as inflation in the 21-country currency bloc is already above 3%, well in excess of the ECB’s 2% target, and economic growth is very weak – a backdrop that has economists split over the case for tighter policy.
Policymakers, some of whom had already pushed for action in April, nonetheless pressed ahead with the unanimous decision, which was accompanied by higher projections for inflation this year and the next but weaker forecasts for growth.
“The war in the Middle East is generating inflation pressures, and the decision to raise rates is robust across a range of scenarios mapping out how the shock might evolve,” ECB President Christine Lagarde said in her opening statement.
However, ECB policymakers see a pause at their next meeting in July as the more likely scenario, if energy prices stay near their current level.
Nevertheless, they remain open to further tightening, possibly as soon as September, partly because the bank’s own updated projections were predicated on more policy tightening, two sources said.
LAGARDE PUSHES BACK ON ‘INSURANCE HIKE’
Economists had expected Thursday’s move, saying it was mainly designed to keep a lid on inflation expectations and safeguard the ECB’s credibility after it was slow to react to a post-pandemic inflation spike in 2022.
Several ECB watchers called it an “insurance hike” – a precautionary step that could be reversed if price pressures fade.
But Lagarde rejected that characterisation, saying the hike was an “obvious” decision that would stand even in a “milder” scenario in which inflation falls below 2% by the spring of next year.
“If we were not taking this very obvious monetary policy decision, then at the end of the medium term that we look out for projection purposes, we would be north of our target,” she told a press conference.
ING’s global head of macro Carsten Brzeski said Lagarde’s comments suggested more tightening is on its way.
“The warning that inflationary pressures were broadening, as well as the emphasis on broadening indirect effects from higher energy prices, suggest that today’s rate hike is not yet the end,” Brzeski said.
INFLATION PROJECTIONS REVISED UP, GROWTH TRIMMED
Supporting the rate hike, the ECB raised its expectations for inflation – substantially for a core measure – while barely trimming the outlook for growth.
The ECB’s new baseline projections for inflation put it at 3.0% this year, 2.3% in 2027 and 2.0% in 2028, bringing them closer to an “adverse” scenario the bank had published in March.
Growth forecasts for 2026 and 2027 were trimmed by 10 basis points and the 2028 figures upgraded by the same degree.
Consumers, companies and financial investors have revised their own views about price hikes, although medium-term expectations remain close to the ECB target and far from their levels following Russia’s 2022 invasion of Ukraine.
A POLICY MISTAKE?
Not all economists are convinced that a hike is justified: some have warned that the ECB risks tightening into an economy that is already paying a high price for the conflict in Iran.
Paul Donovan, chief economist at UBS Global Wealth Management, said the ECB was committing an “error” and was stuck in an “unhelpful 2022 mindset”, referring to the inflation rebound that followed COVID-19 lockdowns.
Analysis of earnings call transcripts by euro zone companies showed just 40% of those outside the financial sector had raised prices or were planning to, roughly half the share seen in 2022 as the Ukraine war pushed up energy prices.
Berenberg’s Holger Schmieding also called Thursday’s decision “a policy mistake” given the stagnant labour market and weak consumer demand.
“Amid the ongoing destruction of demand, the inevitable temporary surge in prices … seems unlikely to turn into a protracted inflation problem that would need to be addressed by higher rates,” he wrote in a note before the meeting.
But the ECB has sharpened its messaging in support of tighter policy. Chief Economist Philip Lane – typically seen as an inflation “dove” – has said the Iran-related shock may be broader in scope than the Ukraine crisis, as it affects global energy markets rather than primarily Europe.
(Editing by Catherine Evans)
