ECB raises rates for first time in nearly 3 years, first among G7 since Iran war

The European Central Bank raised all three of its key policy rates by 0.25 percentage point on Thursday, its first rate hike in two years and nine months, as Middle East-driven inflation concerns forced the bank to reverse course.

Following its monetary policy meeting in Frankfurt, Germany, the ECB said it would lift its deposit rate from 2.00 percent to 2.25 percent per annum, and raise its main refinancing rate and marginal lending rate to 2.40 percent and 2.65 percent, respectively.

The hike is the ECB's first since September 2023. The bank had cut its deposit rate — its primary monetary policy benchmark — from 4.00 percent at that time to 2.00 percent by June last year, only to pivot back toward tightening a year later. The ECB is the first central bank among the G7 major economies to raise rates since surging energy prices, triggered by the Iran war that broke out in late February, began pushing up inflation worldwide.

ECB President Christine Lagarde had initially signaled in March, early in the war, that the bank would look past short-term shocks. But with energy prices proving stubbornly resistant to easing amid the closure of the Strait of Hormuz, the ECB moved ahead with a hike. Officials had already telegraphed the move after the April meeting, acknowledging that the decision to hold rates then had been a close call.

"The Middle East war is generating upward pressure on prices," the ECB said, adding that Friday's decision "keeps us well positioned to navigate the uncertainty created by the conflict."

Reflecting the inflationary trend, the ECB raised its consumer price inflation forecast for the eurozone — the 21 countries that use the euro — from 2.6 percent to 3.0 percent for this year, and from 2.0 percent to 2.3 percent for next year.

The bank trimmed its economic growth forecasts slightly, to 0.8 percent from 0.9 percent for this year and to 1.2 percent from 1.3 percent for next year.

Lagarde said rising energy prices would push inflation higher through the summer and feed through to food, goods and service prices, and projected that consumer prices would remain well above the ECB's 2.0 percent target through the first half of next year. She added that inflation should return to target in the second half of 2027 as energy prices ease and other price pressures moderate, but cautioned that the Middle East war remains a source of ongoing uncertainty.

Lagarde said the war would weigh on the economy through dampened sentiment, lower real incomes from higher energy costs and reduced domestic demand, though she expected public investment in defense and infrastructure to provide at least some support to growth.

Eurozone consumer price inflation came in at a preliminary 3.2 percent year-on-year last month, well above the ECB's medium-term target. Meanwhile, gross domestic product contracted 0.2 percent quarter-on-quarter in the first quarter, stoking fears of stagflation — a combination of high inflation and economic stagnation.

The ECB drew criticism for being slow to raise rates at the start of the Ukraine war when energy prices surged, and some observers suggested the bank was rushing to hike this time even as the eurozone economy struggles, partly to avoid a repeat of that criticism. Lagarde rebuffed the characterization, saying Thursday's decision was unanimous among monetary policy committee members and that the eurozone was not in an environment "without growth or facing a serious threat to it."

Market rates are already pricing in two additional rate hikes. Some analysts, however, argue that tightening monetary policy will do little to tame inflation driven by supply shortages rather than excess demand, and could simply drag on economic activity.

Holger Schmieding of Berenberg Bank called the rate hike "an additional headwind that worsens the damage caused by the Iran war." Jack Allen-Reynolds of Capital Economics said the impact of higher energy prices on inflation "will not be that large," suggesting the ECB's tightening cycle will be short-lived and that the bank is likely to raise rates only once more.

The hike narrowed the gap between the eurozone deposit rate and South Korea's benchmark interest rate of 2.50 percent to 0.25 percentage point, and reduced the spread with the United States — where rates stand at 3.50–3.75 percent — to between 1.25 and 1.50 percentage points. The new rates take effect June 17.