The European Central Bank raised interest rates for the second time this year, with resurgent energy prices sparked by the war in Iran intensifying inflation problems.

The central bank lifted its key deposit rate to 2.5% from 2.25%, after holding rates steady at its July meeting. The move was widely expected by markets. Investors are split over whether the ECB will now pause its tightening campaign, as the trade-offs between containing inflation and damping economic growth crystallize.

The key point

Inflation is heating back up in Europe, climbing to a three-year-high of 3.3% in August after easing earlier in the summer. The ECB forecast in June that inflation would peak later this year and return to its 2% target by 2028.

But renewed fighting in the Middle East could prolong the struggle to bring inflation back down. Global oil prices climbed back above $100 a barrel this week for the first time since July, and natural-gas prices in Europe have jumped to their highest level since 2023.

All eyes on the Fed

The ECB has taken a more aggressive approach to fighting war-driven inflation than many of its peers, leading the pack in June with a rate increase. A majority of investors expect the Federal Reserve to raise rates for the first time this year when it meets next week, according to CME Group data. The Bank of England is expected to raise rates in November.

The ECB had more runway to tighten policy because-unlike in the U.S. or U.K.-its key interest rate heading into the Iran war was well below the level economists view as neutral, neither restricting nor stimulating the economy. Growth has held up surprisingly well this year, with the economy expanding 0.6% in the second quarter, or 0.3% excluding Ireland, where growth is prone to big swings due to its role as a hub for U.S. multinationals. Bank lending has also been resilient in recent months, suggesting interest rates aren't yet weighing on the economy, according to Goldman Sachs.

Time to pause?

Markets are pricing in another rate rise by the ECB in December, but many investors believe the central bank's bar for lifting rates again is rising. Another increase could boost the ECB's deposit rate into so-called restrictive territory, weighing on growth. The run-up in bond yields is also likely to depress economic activity by making borrowing more expensive for businesses, governments and consumers.

Another factor limiting the need for more rate increases: There is little evidence so far that higher energy prices are driving so-called second-round effects that make inflation harder for central banks to contain. For example, workers in the eurozone aren't demanding higher wages, which can lead businesses to lift prices. But that could change if there is no resolution to the conflict and energy prices remain high, ECB executive board member Isabel Schnabel said in August.

"The longer the conflict lasts, the higher the risk and intensity of indirect and second-round effects," said Schnabel.