The European Central Bank has moved to raise interest rates for the first time in nearly three years, with President Christine Lagarde warning that inflation, triggered by the Iran war, is spreading and is no longer confined to the energy sector.
The deposit rate was increased from 2% to 2.25%, aligning with expectations from economists and investors who anticipate another 25 basis-point hike in September. The ECB reiterated that it would not pre-commit to future actions but stated it remains well-positioned to manage the current unpredictability.
President Lagarde told reporters in Frankfurt that the shocks are beginning to propagate "throughout the economy," with "direct costs being evident and indirect costs emerging." She countered suggestions that the unanimous decision to raise rates on Thursday was a pre-emptive move.
She stated, "The main risk would be not making this type of decision, because if you allow inflation to begin rising uncontrollably, bringing it back to price stability becomes a much more difficult situation."
Following the ECB's announcement, European bonds maintained their gains. The euro held steady against the US dollar at $1.1538.
"The outlook remains uncertain, with upside risks to inflation and downside risks to growth," the ECB said in a statement. "The full impact of this war on 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 and second-round impacts."
The ECB's rate hike on Thursday represents the first major central bank policy response following the surge in oil prices triggered by the Middle East conflict. As the war enters its fourth month, eurozone officials are concerned that inflation is broadening from energy into wider areas, and that containing it will not be easy even if a US-Iran peace agreement is reached soon.
These concerns are reflected in the latest quarterly projections. The forecasts show consumer prices rising faster this year than previously expected, before falling back to the 2% target by 2028. However, highlighting the ECB's dilemma, the new outlook also indicates that economic growth will slow as inflation and higher borrowing costs erode purchasing power.
Lagarde said, "The Middle East war is dampening economic activity, with surveys pointing to a slowdown, particularly in services." "Rising energy prices will push inflation higher over the summer and keep it well above target through the first half of 2027."
She downplayed the risks posed by monetary policy tightening to the economy of the 21-nation eurozone, which contracted in the first quarter due to a downturn in Ireland.
Lagarde stated, "We are not in an environment of no growth or where growth faces a major threat."
The ECB had come close to acting in April. Ahead of this week's meeting, even some of its most dovish policymakers indicated there was no real alternative now.
They remain mindful of the situation in 2022, when the Russia-Ukraine conflict triggered record inflation and the ECB was criticized for being slow to react. During that cycle, the deposit rate ultimately reached 4% before cuts began in mid-2024.
This time, officials are paying closer attention to inflation expectations, which have risen significantly. Some fear the situation could worsen due to damage to energy infrastructure in the Gulf region and friction within global supply chains.
Other G7 nations appear less eager to act. The Bank of Canada held rates steady on Wednesday. Next week, the US Federal Reserve and the Bank of England are also likely to stand pat, while the Bank of Japan is expected to continue the gradual tightening cycle it began last year.
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