The breakdown of a ceasefire agreement between the United States and Iran has intensified geopolitical tensions in the Middle East, sharply driving up global oil prices. This has accelerated inflation in the eurozone for July, strengthening hawkish expectations that the European Central Bank (ECB) will need to raise interest rates again. The European statistics agency reported on Friday that consumer prices rose 2.9% year-on-year, up from the 2.8% recorded in June. This figure aligns with the median estimate from a Bloomberg survey of economists, following unexpectedly strong inflation readings in France and Spain.
Within the 21-nation euro area, energy prices surged by an unexpected 10% in July. Both the services inflation gauge and core inflation, which excludes volatile items like fuel and food, also accelerated. This report comes just one week after ECB policymakers paused their benchmark rate increases. The pause was designed to buy time for policymakers to gather more information on how the renewed Middle East conflict will impact eurozone inflation and economic growth. Economists and investors widely anticipate that the ECB will raise rates in September, tightening policy further after a 25-basis-point hike in June.
As illustrated in the chart, eurozone inflation accelerated in July. Source: Eurostat. ECB policymakers held borrowing costs steady at their meeting last week, following the June hike. Recent reports, citing sources, suggest that policymakers are prepared to raise rates again in September unless the inflation outlook shows significant improvement. ECB Governing Council members, including Slovakia's central bank governor Peter Ka么木r, have warned that the ECB cannot simply wait for these effects to materialize, as acting then might be too late.
The fundamental cause of the sharp escalation in the US-Iran conflict is that the brief ceasefire did not resolve the core dispute over control of the Strait of Hormuz and the right to free navigation. A preliminary understanding on June 18 temporarily allowed shipping to resume, but the US subsequently demanded that Iran cease attacks on vessels, fully open the waterway, and not impose transit fees. Iran, in turn, insisted on its control over the strait's security and transit order. In July, the US conducted successive airstrikes on Iran's southern coastal areas, missile and drone facilities to forcibly restore the shipping lane. Iran expanded its retaliatory actions from maritime transport to targets in Qatar, the UAE, Kuwait, and US forces in Jordan.
The direct trigger for the latest escalation was Iran's missile attack on US forces in Jordan. The US responded with approximately two hours of strikes targeting dozens of Iranian Revolutionary Guard command and drone facilities. Simultaneously, the US and Saudi Arabia struck pro-Iranian armed groups in Iraq, while Houthi forces attacked Saudi energy facilities. This transformed the conflict from a bilateral US-Iran confrontation into a multi-front energy war covering the Gulf, Iraq, the Red Sea, and the Eastern Mediterranean. After the US intensified its strikes against Iran in mid-July, traffic through the Strait of Hormuz decreased significantly. Tehran subsequently launched retaliatory attacks on military bases or ports of US allies, including Kuwait. Hostilities resumed this week after a brief ceasefire.
US Energy Secretary Chris Wright stated that oil is still being transported with the support of the US military. "We are using US forces to escort oil and gas out of the Strait of Hormuz," he said in an interview, adding that an average of about 6.5 million barrels of oil per day was shipped from the Persian Gulf through the vital strait over the past week. "We are restoring the supply of oil and refined products from the region to the global market." The renewed conflict in the Middle East is rekindling Europe's inflation curve. Kamil Kovar, head of eurozone forecasting at Moody's Analytics, commented: "Today's data, combined with developments in the Middle East during July, has largely set the ECB on a clear path to restarting rate hikes in September."
German government bonds gave up earlier gains and turned negative, pushing the 10-year yield up 1 basis point to 3.16%. Money markets still price a 90% probability of a 25-basis-point rate hike in September but have slightly increased bets on further tightening, with current pricing indicating a total of 42 basis points of rate hikes for the year. Before the September meeting, officials will also receive August inflation data and the latest economic forecasts prepared by ECB staff. Although ECB President Christine Lagarde declined to pre-commit to action last week, several of her colleagues have almost clearly indicated the future policy direction.
Austrian central bank governor Martin Kocher told media on Friday that "uncertainty and volatility remain high." Earlier, Lithuania's central bank governor Gediminas Simkus stated that the probability of a rate hike is "much higher" than a hold. His Slovak counterpart, Ka么木r, went further, arguing that the ECB must raise rates at least once more, "even if the inflation situation improves." As illustrated in the chart, all eurozone countries except Estonia have inflation rates exceeding the ECB's 2% target benchmark for consumer price changes (year-on-year). The signals from the Middle East are currently mixed. Although the US and Iran have resumed airstrikes against each other, shipping through the Strait of Hormuz has picked up recently. Oil prices, while having fallen back below $100 per barrel, remain at historically high levels.
Meanwhile, an ECB survey shows that wage growth is expected to continue accelerating until early 2027. ECB officials are closely watching wage developments to determine if rising energy costs will keep inflation elevated for longer. Despite this, the eurozone economy has shown remarkable resilience to the crisis so far. Economic output in the second quarter grew at its fastest pace in over a year, doubling expectations, with all four major eurozone economies recording growth. The door is open for a September rate hike. Restarting rate hikes on September 10 is now the base case for the ECB, though it is not a certainty.
The eurozone's July CPI rose from 2.8% to 2.9% year-on-year, core inflation increased to 2.5%, services inflation rose to 3.3%, and energy prices jumped about 10% year-on-year. This indicates that the US-Iran conflict and oil price shock are no longer just affecting headline inflation but are beginning to spread to more sticky underlying inflation. At the same time, the eurozone economy grew by 0.4% quarter-on-quarter in the second quarter, stronger than expected, which reduces the ECB's concern about tightening policy due to recession risk. The market currently prices an approximately 90% probability of a 25-basis-point rate hike in September. The policy stance of the ECB's Governing Council, comprising the governors of eurozone central banks, is clearly hawkish.
The ECB's pause in July was mainly to observe the duration of the energy shock, not to signal the end of the tightening cycle. The official statement emphasized that energy prices remain significantly above pre-conflict levels and the full inflationary impact has not yet materialized. While Lagarde insists on a meeting-by-meeting approach and avoids pre-commitment, she has clearly left the door open for a September rate hike. Ka么木r even believes that at least one more rate hike might still be necessary, even if the situation improves slightly. Unless August inflation falls markedly, oil prices drop rapidly, and wage and services inflation cool simultaneously, the probability of a 25-basis-point ECB rate hike in September is very high. The real uncertainty is not whether there will be one more hike, but whether tightening will continue after September. If the energy price shock is temporary and does not trigger a wage-price spiral, the ECB might adopt a "one insurance hike followed by a pause." If oil prices remain high and push core inflation higher, the total tightening for the year could exceed one rate hike.
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