As expected, the European Central Bank (ECB) increased policy rates at its September meeting, its second rate hike since the start of the Iran war. Rates on the deposit facility, main refinancing operations, and the marginal lending facility were raised by 25bps to 2.50%, 2.65%, and 2.90%, respectively.

The unanimous decision came on the back of the ECB raising its inflation forecasts, with inflation now expected to remain above target through 2027. While ECB President Christine Lagarde did not provide any forward guidance, instead emphasizing the need to keep all policy options open given the fluid nature of the conflict and its potential spillovers, the forecast revisions alongside the continued rise in energy prices imply that further tightening is likely.

Growth: GDP growth has been surprisingly resilient despite the Middle East conflict, with the underlying growth momentum expected to continue. Indeed, activity has been relatively broad-based, bolstered by strong technology investment, increased government spending on defense and infrastructure, and the ongoing recovery in the services sector. The labor market has also remained supportive, with rising productivity helping offset a gradual softening in conditions. Overall, Lagarde noted that the near-term growth outlook has improved, reflecting the strength of consumption and investment. 

Inflation: The energy shock and higher commodity prices remain the primary drivers of inflation, which rose to a three-year high in August. While underlying inflation dynamics remained contained—wages are not overheating, and longer-term inflation expectations are anchored—Lagarde noted that higher energy prices should keep inflation persistently elevated, only gradually returning to target by the end of 2027. This disinflationary process should be supported by higher interest rates. 

Risk scenarios: The highly uncertain environment calls for growth risks to be tilted to the downside, while inflation risks are tilted to the upside. A renewed disruption in energy supplies would weigh on incomes and spending, creating headwinds to economic activity. Tighter global financial conditions could further weigh on growth. Meanwhile, if the energy shock intensifies further, particularly amid a colder winter, then it is likely to drive broader inflation higher through second-round effects. Shortages and supply chain constraints would further exacerbate these effects. 

The latest ECB staff projections reflect upgrades to both the expected paths of growth and inflation, implying a more hawkish tilt for the ECB. Compared with the prior forecasts in June, growth expectations were revised higher in 2026 and 2027, to 0.9% (from 0.8%) and 1.4% (from 1.2%), respectively. Meanwhile, inflation is expected to stay above target for an extended period, with the 2027 forecast revised up to 2.5% (from 2.3%). 

Lagarde noted that these projections underscore a dual phenomenon they’ve observed: first, that the euro area economy is adjusting to the shock better than expected; and second, that inflation spillovers have been lower yet more durable than initially anticipated.