The European Central Bank has raised its benchmark interest rate as a geopolitical energy shock continues to drive up inflation across the eurozone. On Thursday, the ECB's governing council increased the deposit facility rate, its primary policy benchmark, from 2.25% to 2.5%. This marks the second rate hike since June 11, when the central bank implemented its first rate hike in three years.
Alongside the deposit rate, the ECB raised the main refinancing rate to 2.65% and the marginal lending facility to 2.9%. In an official statement, the central bank highlighted that "the conflict in the Middle East continues to generate inflation pressures, and inflation is set to remain well above target for an extended period." However, the governing council emphasized that the decision leaves them "well positioned to navigate the uncertainty caused by the conflict."
ECB staff projections continue to estimate that headline inflation will average 3% this year. However, the bank revised its inflation expectations upward for 2027 and 2028 to 2.5% and 2.1% respectively, compared to its June projections.
The rate hike follows an August inflation reading of 3.3% for the eurozone, up from 2.9% in July, marking the highest level since September 2023. This rise was almost entirely driven by energy costs, with energy inflation surging to 14.3% from 10.3% in July. Geopolitical tensions have heavily impacted energy markets, specifically fighting around the Strait of Hormuz that has restricted crude supplies. These disruptions were highlighted on Wednesday when Brent crude oil prices once again surpassed $100 per barrel following renewed military exchanges between the United States and Iran.
Despite the energy spike, core inflation—which excludes volatile prices for energy, food, alcohol, and tobacco—decreased to 2.4% in August from 2.5%. Similarly, services inflation, which is highly sensitive to wage growth, fell from 3.3% to 3%. The ECB noted there is currently little evidence that high energy prices are spilling over into the broader economy. This distinction is supported by an ECB research paper published earlier this month, which concluded that adverse energy supply factors were responsible for roughly 90% of the energy inflation spike between January and May. The authors noted that "this time the energy supply shock dominates, while demand and public policy stimulus have minor roles," contrasting the current situation with the demand-driven inflation surge of 2021-2022.
The overall eurozone inflation average masks significant national differences. In August, inflation reached 4.5% in Spain, compared to 2.9% in Germany and 2.7% in France. Meanwhile, economic growth across the bloc has remained more resilient than anticipated, though this resilience has not led to overheating. The newly established 2.5% deposit rate is still considered neutral by the ECB, meaning any further increases would transition policy into actively restraining economic activity.
ECB President Christine Lagarde had previously hinted at Thursday's rate hike in July. At that time, the council kept rates steady but requested staff to model various oil and gas scenarios ahead of the September meeting. "The burden of proof is on data," Lagarde remarked in July, warning that "the full inflationary impact of the energy shock has yet to play out."
The ECB's move sets the stage for upcoming decisions by other major central banks. The Federal Reserve is scheduled to announce its policy decision on September 16, followed by the Bank of Japan on September 18, with both expected to debate interest rate hikes. Conversely, the Bank of England is projected to hold its benchmark rate steady at 3.75% during its meeting on September 17.
"This time the energy supply shock dominates, while demand and public policy stimulus have minor roles," the economists wrote, contrasting it with the 2021-22 surge that prompted a far more aggressive response.
Attention now turns to Frankfurt's peers.
