ECB raises interest rates as Middle East conflict fuels inflation concerns

The European Central Bank raised interest rates on Thursday, a move that had been widely anticipated by markets, as policymakers sought to prevent rising energy costs linked to the conflict in the Middle East from triggering broader inflationary pressures across the euro area.

The decision comes as inflation in the 21-member eurozone climbed above 3% last month, significantly exceeding the ECB’s target of 2%.

Higher oil and gas prices have been a key driver of the increase, with policymakers warning that inflationary pressures could persist if the conflict continues longer than expected.

In its policy statement, the ECB said the ongoing conflict was creating inflation risks that justified tighter monetary policy.

"The war in the Middle East is generating inflation pressures, and the decision to raise rates is robust across a range of scenarios mapping out how the shock might evolve and affect the medium-term outlook for the euro area," the ECB said in a statement.

Inflation forecasts revised higher

Alongside the rate increase, the ECB raised its inflation forecasts for the coming years.

The central bank now expects inflation to average 3.0% in 2026, up from the 2.6% projection issued in March.

The inflation outlook for 2027 was also revised upward to 2.3% from 2.0%.

The move reflects growing concerns that elevated energy costs could feed into broader price increases across the economy and influence longer-term inflation expectations among businesses and households.

The ECB had signalled the rate increase well in advance, aiming to reassure markets that it would act decisively to keep inflation expectations anchored despite external shocks.

Balancing inflation risks and economic growth

While inflation concerns have intensified, policymakers continue to face a difficult balancing act as economic growth across the euro area remains subdued.

The ECB lowered its 2026 economic growth forecast to 0.8%, compared with the 0.9% estimate published three months earlier. Growth for 2027 is projected at 1.2%, underscoring concerns about the region's economic momentum.

In its statement, the central bank acknowledged the uncertainty surrounding the outlook.

"The full implications 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," the ECB said.

Market participants currently expect two additional rate increases over the next year as inflationary pressures persist.

However, policymakers are likely to proceed cautiously given the risk that significantly higher borrowing costs could further weaken economic activity and potentially push the bloc closer to recession.

Following Thursday's decision, the ECB's benchmark deposit rate rose to 2.25%, while the main refinancing rate increased to 2.4%.

Focus turns to Lagarde's assessment

Attention later shifted to comments from ECB President Christine Lagarde and newly inaugurated Vice President Boris Vujcic during the post-meeting press conference.

Lagarde highlighted the importance of advancing plans for the digital euro.

"It is essential to swiftly adopt the regulation on the establishment of the digital euro."

She also provided an assessment of current economic conditions, noting that manufacturing activity had remained relatively resilient despite mounting challenges.

Labour market remains resilient

Lagarde said the labour market continued to show strength despite signs of cooling demand.

"The labour market remains resilient. Unemployment at 6.3% in April remains close to historical lows. The first quarter saw additional jobs being created, although at a slower pace than in the last quarter of 2025."

However, she acknowledged emerging signs of weakness.

"Labour demand has cooled further, and firms and households expect the labour market to weaken."

Addressing the broader economic outlook, Lagarde said recent surveys pointed to slowing activity across the euro area, particularly in the services sector.

Meanwhile, the EUR/GBP exchange rate remained largely unchanged in recent days as investors assessed upcoming monetary policy decisions from both the ECB and the Bank of England.

The currency pair was trading at 0.8627, below last year's high of 0.8865, with market participants closely monitoring signals from central bankers on the future path of interest rates.

The ECB's latest decision highlights the challenge facing policymakers as they attempt to contain inflation while supporting an economy that is showing increasing signs of slowing growth.