In response to inflation significantly overshooting its target due to the impact of the Iran conflict, the European Central Bank has increased its key interest rate to 2.25%.
This makes it the first among the world's major central banks to initiate a rate hike cycle in reaction to an energy shock.
The ECB has concurrently raised its inflation forecasts while downgrading its economic growth outlook.
On Thursday, the European Central Bank announced a 25 basis point increase, bringing its main policy rate to 2.25%. The ongoing Iran conflict continues to drive inflation higher, compelling the central bank to adopt a tightening stance.
Data from London Stock Exchange Group indicated that ahead of the June Governing Council meeting, market pricing showed a near 100% probability of at least a 25 basis point hike from the ECB.
The ECB's Governing Council stated that this rate increase is aimed at countering the inflationary pressures stemming from the conflict.
The central bank said in its policy statement: "Hostilities in the Middle East are generating inflationary pressures. We have assessed various potential paths for the energy shock and its impact on the medium-term economic outlook for the euro area. Considering all scenarios, a rate hike is the prudent choice."
The ECB simultaneously revised its inflation projections upwards: it now forecasts average headline inflation for the euro area at 3% for 2026, easing to 2.3% in 2027, and falling to 2% in 2028.
The bank attributed the upward revisions to market expectations of persistently higher energy prices, with the increase expected to feed through to costs across food, goods, and services.
Concurrently, the central bank lowered its economic growth forecasts for this year and next: it now expects average euro area GDP growth of 0.8% in 2026, 1.2% in 2027, and 1.5% in 2028.
Officials cited the downgrade as reflecting the view that "the conflict's impact on commodity markets, household real incomes, and market confidence will be greater than previously estimated."
On Thursday afternoon, ECB President Christine Lagarde reiterated at a press conference that the Middle East conflict continues to push inflation higher.
She stated: "The economic outlook remains uncertain, with upside risks to inflation and downside risks to growth. We will not pre-commit to a fixed rate path."
"The full impact of this conflict on medium-term inflation and growth depends on the duration and intensity of the energy price shock, as well as the scale of indirect and second-round effects it triggers."
The Iran conflict has persisted for over a hundred days. Disruptions to shipping in the Strait of Hormuz and damage to energy production facilities across the Middle East have severely constrained global crude oil supply, triggering widespread energy price volatility. Although a fragile ceasefire is currently in place, tensions have escalated again recently.
The ECB stated on Thursday that the Governing Council "has sufficient policy tools to address market uncertainty arising from the conflict" and will monitor the situation closely, but reiterated that it would not pre-commit to any future interest rate path.
A preliminary reading for eurozone inflation in May, released earlier this month, rose to 3.2%, with surging energy costs pushing inflation significantly above the ECB's 2% policy target.
Eurozone economic growth in the first quarter was a mere 0.1%.
Mark Wall, chief European economist at Deutsche Bank, commented that this rate hike holds symbolic significance.
He wrote in a research note: "This is not only the ECB's first rate hike since 2023, but it is also the first among major global central banks to take a hiking action specifically in response to an energy shock. The ECB is signaling that a strategy of ignoring short-term energy price increases and maintaining an accommodative stance is not viable. However, the room for further tightening in this cycle is limited. We judge that after another hike in September, the hiking cycle will conclude. Upside risks to inflation exist, but downside pressures on economic growth are equally significant and cannot be ignored."
Neil Birrell, Chief Investment Officer at Premier Miton Investors, stated following the central bank's decision that, given the current inflationary environment, this hike was expected.
He said: "It is somewhat reassuring that the central bank has not forecast a deep recession in GDP, although the original growth forecasts were already conservative. Whether further hikes follow will depend on economic data. Further rate increases are highly likely this year, and the policy tightening cycle is far from over."
At 2:50 PM Frankfurt time, the yield on the benchmark German 10-year government bond, a key reference for eurozone debt, fell by 2 basis points. The euro's exchange rate against the US dollar and British pound remained largely unchanged.
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