ECB set to hike rates to 2.25% as Iran war fuels 3.2% inflation

The European Central Bank is expected to raise its deposit rate by a quarter point to 2.25% next week, becoming the first major central bank to tighten policy since the Iran war unleashed an energy crisis that pushed euro-area inflation to 3.2% in May.

"The case for further tightening is less clear-cut and will require additional evidence on pass-through and underlying inflation dynamics," Christian Schulz, chief economist at Allianz Global Investors, said. "For monetary policy, the implication is that the ECB can likely afford a bit more patience."

Consumer prices in the 21-country currency bloc rose 3.2% year-on-year in May, accelerating from 3% in April and more than a percentage point above the 1.7% low struck in January before the conflict began. Core inflation, which strips out volatile food and energy, climbed to 2.5%, its highest level since April 2025. The surge follows the Feb. 28 start of the Iran war, which closed the Strait of Hormuz and sent oil prices spiking, saddling global companies with an estimated $25 billion in added energy costs.

The ECB's Governing Council meets Thursday with the deposit rate at 2%, where it has sat since the bank's last cut in October 2025. Even dovish policymakers including Italy's Fabio Panetta and Greece's Yannis Stournaras have backed a move, making the hike all but certain. The question is what comes next: Traders now price just one additional quarter-point increase this year, most likely in September, down from three hikes fully priced earlier in the war as oil prices have retreated from their peaks. Only 60% of economists in a Reuters poll expect a second move.

The central bank faces a fundamentally different landscape than during the 2022 energy crisis that followed Russia's invasion of Ukraine.

When Russia invaded Ukraine in February 2022, euro-area inflation was already running at 5.9% and the economy was emerging from pandemic lockdowns with pent-up demand and substantial fiscal support. Nearly two-thirds of the region's largest companies passed on higher costs to customers. This time, inflation stood at just 1.9% when the Iran war began, and the backdrop is markedly weaker: GDP expanded just 0.1% in the first quarter, the labor market is less tight, and fiscal stimulus is absent.

A Reuters analysis of 175 euro-area earnings calls found that only 56 companies — about a third — had raised or planned to raise prices in coming months, concentrated among industrial and raw-material firms such as BASF and Nexans. Consumer-facing companies including Delhaize and Volkswagen have been more reluctant to pass on costs, reflecting subdued household demand. That compares with 108 of 132 non-financial companies that did so in the spring of 2022.

"The jury is still out on how persistent the price effects will be, and it's far too early to sound the all-clear," Spyros Andreopoulos, founder of Thin Ice Macroeconomics, said. A study by the Bank of Finland suggests it can take between two and 15 months for price rises in individual sectors to filter through into overall consumer inflation.

Forward-looking indicators offer the ECB mixed signals on whether price pressures are broadening.

Selling price expectations among firms stabilized in May after a spike in April, and consumer inflation expectations also eased or held steady in the latest readings. Long-term expectations remain near the ECB's 2% target. Yet services inflation ticked up in May, and the Easter holiday may have distorted the data, meaning policymakers will want to see more details before declaring the worst over.

ECB Chief Economist Philip Lane has said the bank will revise up its inflation forecasts at this meeting, while board member Isabel Schnabel noted that the energy shock has persisted beyond what the bank's adverse scenario assumed. The updated projections will be closely watched for the core inflation forecast in particular — a significant upward revision could reignite market bets on a more aggressive tightening path.

"If they revise up the forecasts a lot for core inflation, that is something that can increase market expectations about rate hikes," Pia Fromlet, economist at SEB, said.

The ECB's decision Thursday will set the tone for global central banks navigating the same dilemma: how to contain war-driven inflation without crushing already-weak growth. The next meeting is scheduled for July 23, though most analysts expect the second hike to come in September, when the council will have fresh staff projections and more clarity on the conflict's trajectory.

This article is for informational purposes only and does not constitute investment advice.