The European Central Bank has raised its deposit rate to 2.5%, the second increase since the Iran conflict sent oil and gas prices sharply higher, and President Christine Lagarde has warned that the inflation shock driving the moves will persist longer than the bank previously anticipated.

In an interview with Ouest-France published by the ECB on Saturday, Lagarde said the current shock is longer-lasting, pointing to the ongoing Middle East conflict and the destruction of refining capacity around the world, especially in Russia. Those factors have led to an increase in energy costs, and that drives all prices higher, she added. Her message was direct: in this kind of situation, and as we also have a resilient economy, we are obliged to react.

Energy prices and the Middle East conflict

The Iran war has upended the ECB's inflation outlook in a way that few forecasters anticipated. When the conflict erupted, the immediate focus was on oil supply disruptions, but the damage to refining capacity, particularly in Russia, which has faced drone attacks on its energy infrastructure, has created a structural tightening in global fuel markets that is not easily reversed. Lagarde's acknowledgement that the shock will last longer than expected marks a shift from the transitory language the bank used during the 2021-22 energy crisis.

Euro-area inflation remains above 3%, well above the ECB's 2% medium-term target. The bank's latest staff projections, released on Thursday, now show inflation running quicker in 2027 and 2028, with 2028 slightly above target. That is a notable revision: previous projections had inflation returning to 2% by 2026. The persistence of energy-price turbulence means the pass-through to services and food prices continues, keeping headline inflation elevated even as goods disinflation proceeds.

Growth resilience complicates the calculus

The same projections that raised the inflation path also upgraded growth forecasts, highlighting what Lagarde called the euro area's resilience despite the Middle East conflict and additional drags such as US trade policies. That resilience is a double-edged sword. It gives the ECB cover to keep tightening without triggering a deep recession, but it also means demand-side pressures are not fading as quickly as they might in a weaker economy. The result is a policy rate that officials acknowledge may already be at the top of the neutral range, yet still insufficient to bring inflation back to target on the current trajectory.

Philip Lane, the ECB's chief economist, regards the 2.5% deposit rate as about the top of the neutral range, the level that neither stimulates nor restricts the economy. If that assessment holds, further hikes would push policy into restrictive territory. That is precisely what Bundesbank President Joachim Nagel signalled on Friday, saying borrowing costs may have to move into mildly restrictive territory to tame price growth. The divergence between Lane's neutral-range view and Nagel's call for restriction encapsulates the debate now playing out on the Governing Council.

Diverging views on the neutral rate

The concept of the neutral rate is notoriously difficult to pin down in real time, and the ECB's own estimates have shifted repeatedly over the past three years. What makes the current moment unusual is that two of the most influential voices on the council are signalling different conclusions from the same data. Lane's neutrality assessment suggests the bank has done most of the heavy lifting; Nagel's restrictive-territory argument implies the job is unfinished. Markets have priced in at least one more increase by year-end, but the path beyond that depends heavily on whether energy prices stabilise or spike again.

The ECB's own projections assume a gradual decline in energy prices over the projection horizon. If the Middle East conflict escalates further, or if Russian refining outages prove more persistent than assumed, those forecasts will be obsolete before they are published. Lagarde's language, the current shock is longer-lasting, suggests she is less confident in the baseline than the projections imply.

Transmission to households and businesses

For euro-area households, the immediate effect is higher mortgage costs. Variable-rate mortgages reset quickly, and even fixed-rate borrowers face significantly higher rates when they refinance. Corporate lending rates have also risen, though the pass-through varies by country and sector. The ECB's bank lending survey shows credit standards tightening further in the second quarter, with demand for loans weakening. That transmission is working as intended, but the lag means the full impact of the two hikes since the Iran war will not be felt until well into 2027.

There is also a fiscal dimension. Higher rates increase debt-servicing costs for governments that have issued short-dated paper or relied on floating-rate instruments. Italy and France, with debt-to-GDP ratios above 110%, are particularly exposed. The ECB's transmission protection instrument remains available, but it has never been tested and its activation criteria are stringent. The bank will be reluctant to intervene unless fragmentation risks become acute.

People mentioned

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European Central Bank · Deutsche Bundesbank