Latvian ECB governor signals rate hikes as Middle East war keeps oil prices elevated

The European Central Bank is edging closer to raising interest rates again as the war in the Middle East keeps oil prices above the levels policymakers built into their central forecast. Mārtiņš Kazāks, governor of the Bank of Latvia and a member of the ECB Governing Council, said in an interview published on 18 May that the closure of the Strait of Hormuz and the resulting disruption to energy supplies are hitting the euro-area economy harder than the bank anticipated just two months ago.

Where the ECB scenarios now stand

In March the ECB published two economic scenarios tied to escalating Middle East tensions. The baseline assumed quarterly average oil prices peaking around $90 a barrel in the second quarter of 2026, with inflation rising to 2.6% this year before returning to the 2% target in 2027. The adverse scenario saw oil averaging $119, inflation surging to 3.5% and remaining above target next year as higher energy costs ripple through the economy. The baseline scenario, Kazāks noted, prices in two interest-rate increases.

"The war [in the Middle East] is dragging on longer and the price level for oil is higher than we had expected in the baseline. So it pushes us more towards the adverse scenario," Kazāks said, speaking to POLITICO on 14 May. "We are currently between the baseline and the adverse scenario. Unless the economy suffers another much deeper shock, for example energy shortages, then the direction of the policy rate is relatively clear."

At its most recent policy meeting the ECB left its key rate at 2%, stating it would monitor incoming data before deciding whether a response is needed to prevent high energy prices from feeding into broader inflation. Kazāks reiterated that decisions remain data-dependent but added he sees little sign of the kind of economic contraction that would by itself bring inflation down and justify looser policy.

A 'layer cake' of overlapping shocks

The Latvian governor described the current global environment as a "layer cake" of shocks, each evolving and interacting with the others in ways that make policy formulation increasingly difficult. "There are simply more possibilities to make mistakes," he said. The observation reflects a broader concern within the Governing Council that the traditional transmission mechanisms of monetary policy are being complicated by simultaneous supply-side disruptions, energy, food, shipping routes, that are fundamentally political in origin.

Kazāks's own background informs his scepticism about economic pain translating quickly into political change. He grew up in Soviet-occupied Latvia in a household without running water, and he points out that living standards outside Moscow and St Petersburg remain comparatively low. That, he argues, gives the Russian population a historically high threshold for economic suffering, a point underscored by the limited domestic reaction to Ukrainian drone strikes on Russian oil and gas infrastructure in recent weeks. Those attacks have interrupted air and rail travel and forced temporary mobile-internet shutdowns, making the war's costs more visible, yet the political calculus in the Kremlin appears unchanged.

Why Russian economic weakness will not end the war

Kazāks was blunt in dismissing the hope that mounting economic pressure on Moscow could force Vladimir Putin to seek peace in Ukraine. "Russian economic weakness is a necessary but not a sufficient condition for an end to the war," he argued. "Betting that economic costs alone would force Russia to stop the war is naïve and I would even say it's dangerous."

The distinction matters because it shifts the burden of action onto Europe. If Russian weakness is not enough, then European strength becomes the decisive variable. Kazāks cited the findings of Mario Draghi's report on the future of European competitiveness, which concluded that internal trade barriers within the single market impose costs equivalent to tariffs higher than the 15% the United States has threatened. "The U.S. scares us with 15 percent tariffs," Kazāks said, highlighting Draghi's conclusion that Europe's own fragmentation is a larger drag on growth.

Internal barriers and the Draghi agenda

The Draghi report, commissioned by the European Commission and published in 2024, identified a range of structural weaknesses: fragmented capital markets, duplicated defence procurement, regulatory divergence in digital services and energy, and a venture-capital gap relative to the United States. Kazāks singled out internal trade barriers as a concrete example where Europe fails to fulfil its economic potential. Removing them, he argued, would deliver a larger growth boost than any plausible external trade deal.

Progress on the Draghi recommendations has been uneven. The European Council endorsed the report's broad direction in mid-2024, but legislative follow-through on capital-markets union, a unified telecoms market and joint defence procurement has stalled amid national vetoes and electoral cycles. Kazāks's intervention adds weight to the argument that the cost of inaction is now measured not just in lost GDP but in strategic vulnerability.

Operating from a position of strength

Kazāks set out a sequence: support Ukraine, invest in European military capacity, reduce fragmentation, and strengthen the economy to sustain the first three. "If we support Ukraine, if we Europeans invest in our military, if we reduce fragmentation in Europe, if we have a military that is up to the task, and we can do that only if we strengthen our economies, then we can act from a position of strength," he said. "That requires more integration or less fragmentation in Europe, both in military procurement, but also in terms of financial markets among other things."

The logic links monetary policy to geopolitical strategy. Higher interest rates, if they become necessary to anchor inflation expectations, will raise the cost of public borrowing across the euro area. That makes the case for shared fiscal instruments, a common defence fund, joint procurement bonds, a deeper capital-markets union, more urgent, not less. Kazāks did not spell out the fiscal implications in the interview, but the connection is implicit in his emphasis on strengthening economies as the precondition for credible defence.

What the data will show next

The next ECB policy meeting is scheduled for June. Between now and then, the Governing Council will receive updated inflation projections, labour-market data, and a clearer picture of whether oil prices are stabilising near current levels or retreating. Kazāks's framing suggests that unless a sharp economic downturn materialises, the "much deeper shock" he referenced, the bias is toward tightening. The risk, as he acknowledged, is that the layer cake of shocks produces an outcome no scenario captured: a simultaneous energy-price spike and demand collapse that would leave the ECB with no clean policy move.