The European Central Bank raised its key interest rate by 25 basis points on Thursday, as widely anticipated, lifting the deposit facility rate from 2% to 2.25%. This marks the central bank's first rate increase in three years.

The ECB determined it could no longer delay action until after the conclusion of the Middle East conflict, given mounting inflationary pressures. While markets currently anticipate another 25-basis-point hike from the ECB in September, the central bank reiterated that it would not pre-commit to any future policy path, stating it retains the capacity to navigate the current uncertain environment.

In its statement, the ECB noted, "The outlook remains uncertain, with upside risks to inflation and downside risks to economic growth." It added, "The full impact of the war on 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 effects and second-round impacts."

This move represents the first policy response by a major central bank to the surge in energy prices triggered by the Middle East conflict. As the conflict enters its fourth month, eurozone officials are concerned that inflationary pressures are no longer confined to the energy sector. Even if a peace agreement between the U.S. and Iran is reached soon, damage to energy infrastructure in the region implies that restoring output will take time, potentially preventing a swift decline in inflation.

The latest eurozone inflation data has risen to 3.2%, with upward pressures intensifying. Even when excluding volatile energy and food components, core inflationary pressures have increased substantially. Corporate pricing plans and households' long-term inflation expectations are also on the rise.

Several policymakers had previously signaled that the central bank could no longer ignore this round of energy price shocks and must uphold market confidence in its commitment to the 2% inflation target.

This concern about the inflation outlook is reflected in the ECB's latest quarterly economic projections. The new forecasts indicate that eurozone inflation will reach 3.0% in 2026, up from the 2.6% projected in March. The inflation measure is expected to fall to 2.3% in 2027 (higher than the 2% forecast in March) and return to the 2% target in 2028.

The projections also show that core inflation, excluding food and energy, will reach 2.5% in 2026 (up from 2.3% projected in March), remain at that level in 2027, and then decline to 2.2% in 2028.

Simultaneously, the forecasts downgraded economic growth expectations for the eurozone for this year and next. The ECB now expects eurozone GDP growth of 0.8% in 2026, down from the 0.9% forecast in March, and growth of 1.2% in 2027, lower than the previous 1.3% projection.

These latest projections highlight the ECB's dilemma: inflation remains persistently high while the economic growth outlook continues to weaken.

ECB President Christine Lagarde is scheduled to hold a press conference later in the day to elaborate on these views. Further details regarding the projections and scenario analysis will also be released later.

It is worth noting that the ECB was close to acting in April, and even some of the most dovish policymakers hinted ahead of this week's meeting that there was effectively no other choice now. They vividly recall the experience of 2022, when the outbreak of the Russia-Ukraine conflict triggered a record surge in inflation, and the ECB faced criticism for its slow response. In that cycle, the deposit facility rate eventually rose to 4% before the ECB began a rate-cutting phase starting in mid-2024.

This time, ECB officials are on higher alert regarding inflation expectations, as these have risen significantly. Some worry that damage to energy infrastructure in the Gulf region and increased global supply chain frictions could worsen the inflation situation.

In contrast, central banks of other G7 member nations are not rushing to act. The Bank of Canada held rates steady on Wednesday. Next week, the U.S. Federal Reserve and the Bank of England are also expected to keep policy unchanged, while the Bank of Japan is anticipated to continue the gradual monetary tightening cycle it began last year.

A Replay of the 2011 Rate Hike Debacle?

Ahead of today's ECB decision, markets widely expected the central bank to act. Officials appeared convinced of the necessity to raise rates now to prevent soaring energy prices from triggering a broader inflationary wave.

However, some economists warn that the ECB's determination to defend its inflation-fighting credibility could lead it into a costly mistake. They argue that compelling reasons for the ECB to remain on hold and proceed cautiously still exist—the eurozone economy is faltering, and market investors are prone to interpreting a single rate hike as the start of a new cycle of consecutive increases.

Historical precedents are clear. In July 2008, the ECB chose to raise rates, only for Lehman Brothers to collapse shortly after, forcing the central bank to execute an emergency about-face and cut rates within months. But more economists draw parallels with 2011—when then-President Jean-Claude Trichet raised borrowing costs twice, only for his successor Mario Draghi to cut rates by year's end. At that time, policymakers were similarly worried about surging commodity and energy prices but underestimated the fragility of the eurozone's financial system, ultimately contributing to a double-dip recession for the region.

Davide Oneglia, an economist at TS Lombard, stated, "The ECB is single-mindedly focused on proving its policy credibility. The 2011 rate hikes were a complete policy mistake. Now, with the central bank overly focused on inflation expectations and haunted by the psychological scars of 2022's high inflation, repeating that error is one of the biggest risks."

Although eurozone inflation measures have risen, some analysts believe the increase in core inflation is not solely due to the pass-through of energy costs. Another view suggests that core price indicators, such as wages, have not yet shown signs of excessive upward movement.

Michala Marcussen, Chief Economist at Societe Generale Group, noted, "If the ECB raises rates before there is clear evidence of second-round inflation transmission effects, it risks unnecessary tightening—it's taking a gamble."

Holger Schmieding, Chief Economist at Berenberg Bank, believes an ECB rate hike would merely impose unnecessary burdens on households and businesses, arguing that economic weakness itself will gradually alleviate inflationary pressures. He stated bluntly, "There is absolutely no need for the central bank to raise rates while people are under pressure. With domestic demand persistently weak, this brief uptick in prices is unlikely to evolve into a long-term inflation crisis requiring intervention via rate hikes."

However, another school of thought supports the rate increase, arguing that even if subsequent weak economic data forces a policy pivot, the hike itself remains justified. Katharine Neiss, Chief European Economist at PGIM, suggested policymakers would leave themselves ample room for maneuver, "so that if the economic fundamentals deteriorate substantially and various sentiment surveys continue to weaken, they can signal at any time that rate cuts are possible."