ECB Raises Rates by 25 bps as Middle East Conflict Lifts Inflation Risks

Markets

The European Central Bank delivered an expected 25 basis-point rate increase, lifting its policy rate to 2.25%, as the war in the Middle East adds to inflation pressures. The central bank said the shock supports a hike “across a range of scenarios,” while keeping its forward guidance deliberately flexible: it will remain data-dependent and take decisions meeting by meeting. Updated projections, however, point to at least one additional increase. The ECB raised its headline inflation forecasts for 2026–2028 to 3.0%, 2.3% and 2.0%, from 2.6%, 2.0% and 2.1% in March. Higher energy costs are expected to feed partly into food, goods and services prices, lifting core inflation projections to 2.5%, 2.5% and 2.2%, all above the 2% target over the policy horizon. Growth forecasts were trimmed slightly to 0.8% this year and 1.2% next year, as the conflict weighs more heavily on commodity markets, real incomes and confidence, while the 2028 outlook was revised up to 1.5%. Inflation risks are skewed to the upside, including energy prices, wage and price spillovers, supply-chain fragmentation and raw-material shortages. Growth risks are tilted lower, reflecting the possibility of a prolonged conflict, sustained higher energy prices, trade frictions and supply disruptions. The final economic impact depends on the intensity and duration of the energy shock and the extent of indirect second-round effects.

During the Q&A, ECB President Christine Lagarde said the decision was unanimous, with no alternative proposals, such as a larger hike or no change, discussed. She declined to signal what to expect next month or later this year, but emphasized that today’s increase should not be viewed as an insurance move. Instead, the ECB is reacting to signs that the initial energy shock is broadening. Lagarde added that the central bank has developed a “milder” scenario alongside adverse and severe cases relative to the baseline. While she said that scenario is unlikely to materialize, the ECB still viewed today’s hike as appropriate even under those conditions. Lagarde did not specify which scenario applies now, but referred to her March speech outlining the bank’s reaction function in three possible cases. Of those, she dismissed the “see-through-the-shock” case. The second case — a large but not overly persistent inflation overshoot requiring a measured policy adjustment — appears to be the dominant one. She sounded relatively relaxed on growth, saying, “It’s not as if we are in an environment where growth is absent or under significant threat.” With that, the door remains open for another measured adjustment. Money markets have raised bets on back-to-back action in July, with a hike currently priced at around 65%. The broader market reaction was clouded by Donald J. Trump, who said in a social media post before his press conference that the US would hit Iran “very hard tonight.” He also threatened to “assume total control of” Iran’s oil and gas markets by taking Kharg Island, Iran’s key oil export artery, “at some point.” Oil prices jumped from intraday lows around $92 to $94, core bond yields recovered earlier losses and the euro fell against the US dollar. Those moves later reversed, suggesting investors are not fully buying into the threat. That skepticism could backfire.

News & Views

In Norges Bank’s Q2 Regional Network Survey, contacts lowered growth expectations for the current quarter from 0.4% to 0.2%, but expect activity to pick up in Q3 to 0.3%. All sectors except oil services anticipate higher activity ahead, even as customers become more cautious. Investment in defence and emergency preparedness is supporting commercial services, while construction remains weak. Fewer contacts report capacity constraints, and the share facing recruitment difficulties has eased somewhat. Thirty percent of respondents report full capacity utilization, an indicator that has gradually declined to its lowest level since 2020. Hiring challenges have also eased for areas such as IT expertise, though shortages remain for several other skilled roles. Even so, estimated wage growth for this year and next has been revised up to 4.5% and 4.1%, from 4.2% and 3.9% in the Q1 survey. The NOK 2-year swap yield fell 5 bps. Markets see less than a 20% chance of a 25 bps hike next week, while September is priced at around 90%. The krone weakened slightly further to EUR/NOK 10.99.

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