ECB to raise key rate to 2.75% as Middle East conflict fuels inflation

The European Central Bank will raise its key interest rate Thursday for the first time in three years, becoming the first major central bank to tighten policy in response to energy price spikes from the Middle East conflict.

The ECB will lift its deposit rate to as high as 2.75% from 2% on Thursday, economists expect, as annual inflation accelerated to 3.2% in May — the first rate increase by a major central bank triggered by the conflict in the Middle East.

"We expect the ECB to strike a delicate balance between not calling the hike a 'one-and-done' hike while also stopping short of pre-announcing further hikes," said Carsten Brzeski, an economist at ING. "Let's call this a gently hawkish tone."

The eurozone economy contracted in the first quarter, leaving it at risk of recession, while annual inflation rose to 3.2% in May from 1.9% in February, driven largely by higher energy costs. Retail sales fell in April as consumer confidence slumped, and business surveys point to a possible contraction in the second quarter. The euro traded above $1.15 on Thursday as traders priced in the rate increase, according to FXStreet data.

The rate decision marks a test of whether the ECB can contain second-round inflation effects from the energy shock without deepening a downturn. President Christine Lagarde's press conference will be scrutinized for guidance on whether this is the start of a tightening cycle or a single move — the OECD forecasts just one hike, while most economists expect two.

The Rate Path Debate

Investors see at most three quarter-point moves, which would take the key rate to 2.75% from 2%. The last ECB hiking cycle ran from July 2022 to September 2023 and delivered 10 consecutive increases totaling 450 basis points as the central bank fought post-pandemic inflation. That cycle ended when the economy weakened and inflation began to moderate.

This time, the calculus is different. The inflation surge is supply-driven — tied to the Strait of Hormuz disruption and energy prices — rather than demand-driven. Central bankers worry that higher energy costs will feed into wage demands and create second-round effects, though most eurozone wage deals are negotiated at the start of the calendar year and there is little evidence of that pass-through yet.

"After that, the debate could heat up. Growth concerns are mounting," said Simon Wells, an economist at HSBC, referring to the path beyond Thursday's expected move.

Peers Hold Fire

The Federal Reserve and the Bank of England hold policy meetings later this month, but neither is expected to raise borrowing costs. The Bank of Japan is expected to raise rates on June 16 as policymakers grow more concerned that the conflict will accelerate underlying inflation.

The ECB's move makes it the first among its peers to respond to the energy shock with tighter policy. Much depends on how long the Strait of Hormuz remains blocked and how high energy prices rise from here. If the conflict ends soon, the OECD projects the ECB could reverse the hike by late 2026.

"It would be very unusual for the ECB to raise rates just once, and it would risk looking like a token gesture rather than a meaningful response," said Jack Allen-Reynolds, an economist at Capital Economics.

The ECB will publish new economic forecasts alongside the decision, which are likely to show higher inflation and weaker growth than the March projections.

This article is for informational purposes only and does not constitute investment advice.