Hormuz conflict forces ECB to weigh rate hold as oil surges past $85

A week of escalating military exchanges between the United States and Iran over control of the Strait of Hormuz has shoved oil prices back into the centre of the European Central Bank's calculus, just days before its July 22 monetary policy meeting. Brent crude futures for September delivery climbed above $85 a barrel on Wednesday, up from roughly $70 a week earlier, as traders priced in the risk of sustained disruption to the waterway that carries about a fifth of global oil supply.

Oil shock returns to the fore

The speed of the repricing has been striking. Only last month, a decline in energy costs helped convince investors that the ECB's hiking cycle was over. Now, with the Hormuz strait again a flashpoint, the market-implied probability of a rate increase next week has edged up to around 20%, and forward curves show two further quarter-point moves by spring 2027, which would lift the deposit facility to 2.75%.

For the euro area, the exposure is direct. The bloc imported 57% of its energy needs in 2024, according to Eurostat, leaving it acutely sensitive to supply shocks in the Gulf. The last time Hormuz tensions flared, in late 2023, the pass-through to headline inflation was swift and broad. Policymakers are determined not to be caught out a second time.

A policy path reversed

The ECB's recent trajectory illustrates how quickly the outlook can shift. Between January and June 2025 the Governing Council cut the deposit rate four times, taking it from 3% to 2%, as inflation appeared to be on a sustainable descent toward the 2% target. Then came the May flash estimate: headline inflation at 3.2%, driven by an 8.7% year-on-year surge in energy prices. The response was an immediate 25 basis point hike to 2.25% at the June meeting, a reversal that underscored the institution's nervousness about second-round effects.

June's final reading offered some relief. Headline inflation eased to 2.8% even as energy costs kept rising, while core inflation, the measure that strips out energy, food, alcohol and tobacco, held at 2.4%. That suggested wage-price spirals had not yet taken hold. But the data window is narrow. The next full inflation print arrives on July 31, nine days after the rate decision, and second-quarter GDP is not published until July 30.

Growth concerns complicate the calculus

The growth backdrop adds another layer of difficulty. The euro area economy contracted 0.2% year-on-year in the first quarter of 2026, the first annual decline since the pandemic recovery. A further tightening risks deepening that contraction, particularly in rate-sensitive sectors such as construction and manufacturing. Yet leaving rates unchanged while oil climbs could entrench inflation expectations, forcing a larger correction later.

This dilemma was laid bare by Joachim Nagel, president of the Bundesbank and a member of the Governing Council. Speaking to Reuters on Wednesday, he said: "The renewed outbreak of military conflict in the Middle East and the fresh rise in oil prices underscore that the situation remains extremely volatile and the uncertainty is similarly high. It remains advisable to react with caution, but to act decisively if necessary. Monetary policy will maintain its vigilant stance."

Second-round risks under scrutiny

Nagel's Austrian counterpart, Martin Kocher, governor of the Oesterreichische Nationalbank, struck a similar note in an interview with Börsen-Zeitung. "At the moment we are paying particular attention to the indirect price effects of the war in the Middle East and possible second-round effects," he said. "We currently see no second-round effects, but must also align our monetary policy with inflation expectations." The distinction matters: if higher energy costs feed into wage demands and service prices, the ECB would face a more persistent inflation problem than a simple supply shock.

So far, the evidence is mixed. Negotiated wage growth in the euro area has moderated from its 2024 peaks, and corporate profit margins, which absorbed some of the earlier cost increases, are thinner now. But consumer inflation expectations, measured by the ECB's own survey, ticked up in the latest reading, and the longer oil stays above $85, the harder it becomes to anchor those expectations.

Markets diverge from the Fed

The uncertainty is also widening the gap between European and US rate expectations. ING rates strategists Michiel Tukker and Benjamin Schroeder noted on Wednesday that "the momentum in US inflation should be downwards, whereas for Europe the peak might not be in sight yet, especially if energy prices continue to drift higher again." The Federal Reserve is widely expected to begin cutting in September, while the ECB may still be hiking, an unusual divergence that could pressure the euro and further import inflation.

Currency moves have so far been contained. The euro has slipped about 1.5% against the dollar since the Hormuz hostilities resumed, but it remains well above the lows seen during the 2022 energy crisis. A sharper depreciation would amplify the oil shock, since crude is priced in dollars, creating a feedback loop the ECB will want to avoid.

Data vacuum ahead of decision

The Governing Council will meet on July 22 without two critical data points: the flash estimate for second-quarter GDP and the July inflation reading. Both are scheduled for the following week. That means the decision will rest on monthly indicators, industrial production, retail sales, business surveys, and on the judgement of national central bank governors who sit on the council.

Recent monthly data have been equivocal. Industrial production in May rose 0.6% on the month but was still down 1.8% year-on-year. Retail sales volumes fell 0.3% in May. The composite PMI for June edged up to 50.7, barely in expansion territory. None of these figures offers a clear signal, which may argue for a hold, but the oil price move since the June meeting is a new variable that did not exist when the council last convened.

What the meeting may decide

Most economists still see a hold as the base case. A Reuters poll of 45 analysts conducted before the latest oil spike showed 38 expecting no change, five forecasting a hike, and two a cut. But the distribution has shifted: the probability of a hike, negligible a fortnight ago, is now openly discussed. The council's communication will matter as much as the rate decision itself. If President Christine Lagarde signals that the door to further tightening remains open, markets will keep pricing a higher terminal rate.