ECB raises rates for first time since 2023 as Iran war drives inflation

The European Central Bank raised its main deposit rate by a quarter point to 2.25% on Thursday, the first increase since 2023, as the war in Iran pushes energy costs higher and forces the central bank to abandon its wait-and-see stance. The move takes the rate on the main refinancing operations to 2.4% from 2.15%. Financial markets immediately priced in two further hikes by March 2027, though at least one prominent economist argues the cycle will end after a single additional increase in September.

Inflation breaks above 3% as oil stays above $90

Eurozone consumer price inflation accelerated to 3.2% in May 2026, up from 3% in April, according to Eurostat's flash estimate. The ECB's target is 2%. The jump reflects an energy shock that has kept Brent crude above $90 a barrel since the Iran conflict escalated, compared with roughly $70 before the war began. Higher oil and gas prices are already feeding through to manufacturing and retail prices, with companies passing on costs to protect margins.

Christine Lagarde, president of the ECB, acknowledged the uncertainty. "The full implication of the war for 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 and second-round effects," she said at the post-meeting press conference. The governing council had considered "looking through" the energy-driven price rise as recently as March, but concluded that the pass-through to broader inflation was already visible.

Growth forecasts cut as downside risks mount

The ECB lowered its growth projections for the eurozone to 0.8% this year and 1.2% in 2027, down from 0.9% and 1.3% respectively in the March staff projections. Lagarde said risks to the outlook are "to the downside, mainly owing to the war in the Middle East, which has added to the volatile global policy environment." Prolonged disruption to energy supplies could push prices higher for longer than currently assumed.

The downgrade reflects a difficult balancing act. The central bank held rates steady for months in the hope that a US-Iran peace deal would ease energy markets. That deal has not materialised. With inflation now entrenched above target and the labour market still tight in several large member states, the governing council judged that further delay would risk de-anchoring inflation expectations.

A significant moment for global central banking

Mark Wall, chief European economist at Deutsche Bank, called the decision a watershed. "This is a significant moment. Not only is this the first ECB hike since 2023, it is also the first hike by one of the major global central banks in response to the energy shock. The ECB is saying that a 'look through' strategy is not a robust response," he said. Wall's phrasing captures the broader implication: the ECB has become the first major central bank to tighten explicitly because of the Iran war's inflationary impact.

Wall disagrees with market pricing, however. He expects only one more quarter-point increase in September, taking the deposit rate to 2.5%, and then a pause. "The question is how far can this tightening cycle go. Not far is our answer. There is upside risk to inflation, but there is also downside risk to growth," he said. Unemployment is rising in several eurozone economies and growth is slowing, which he argues will limit the ECB's appetite for further moves.

Divergence with the Bank of England and Federal Reserve

The ECB's move puts it ahead of its peers. The Bank of England is expected to hold UK rates at 3.75% when its monetary policy committee meets next week, despite UK inflation falling to 2.8% in April and projected to rise again this summer as energy costs feed through. The US Federal Reserve is also widely expected to keep its policy rate unchanged, even though US inflation stands at 4.2%, the highest in the G7.

The divergence reflects different starting points and mandates. The Fed has kept rates higher for longer and is wary of overtightening after the aggressive cycle of 2022-23. The BoE faces a tighter labour market and sticky services inflation but also a more pronounced growth slowdown. The ECB, by contrast, is reacting to a supply-side shock that is disproportionately European given the region's energy import dependence.

Why the ECB moved now rather than later

The decision carries echoes of 2022, when the ECB was criticised for delaying rate rises after Russia's invasion of Ukraine. That hesitation forced a steeper tightening cycle later, which some economists argue contributed to the subsequent recession in Germany and near-stagnation elsewhere. This time, the governing council appears determined to act pre-emptively, even at the cost of further dampening an already fragile recovery.

The calculus is complicated by the nature of the shock. Energy-driven inflation is not easily tamed by higher interest rates, which work primarily by damping demand. Raising rates cannot lower oil prices; it can only prevent second-round effects such as wage-price spirals. The ECB's own staff projections assume energy prices stabilise, but the war's trajectory is inherently unpredictable.