As expected, the European Central Bank (ECB) increased policy rates today, its first hike since 2023. Rates on the deposit facility, main refinancing operations, and the marginal lending facility were raised by 25bps to 2.25%, 2.40%, and 2.65%, respectively. 

ECB President Christine Lagarde characterized the decision as a measured response given the balance of risks facing the outlook. She also noted that no other policy options were discussed. She pushed back against the notion that the ECB was acting preemptively and that a hike may prove to be a policy error, saying that the impact of the energy shock has begun to materialize in the data. 

Growth: The latest data showed that the euro area continued to grow, supported by domestic activity and exports. This has been underpinned by higher defense spending, AI-related investment, and a resilient labor market. Yet, recent surveys suggest that the fallout from the Middle East conflict is already weighing on economic activity, especially in services. As a result, domestic demand is expected to weaken as the energy shock erodes real incomes, in turn dampening consumption which has been the main driver of growth.

Inflation: Price increases have continued to accelerate due to both higher energy prices and an increase in core inflation. Rising input costs have also caused firms to expect to raise prices, pointing to further inflationary pressures that will materialize. Additionally, while longer-term inflation expectations remain anchored, shorter-term expectations have risen notably. As the conflict remains fluid, monitoring the magnitude and persistence of energy price increases, as well as signs of any pass through to broader goods, remains vital.

Risk scenarios: While growth risks are tilted to the downside, President Lagarde stressed that growth is not under significant threat. Meanwhile, she noted that inflation risks were tilted to the upside. She noted that elevated energy prices could trigger broader inflation that could de-anchor inflation expectations and make controlling inflation much harder. However, as the ECB’s wage trackers do not yet indicate an acceleration in wage pressures, Lagarde expressed confidence that problematic second-round effects of higher energy prices on inflation have not yet materialized.

The evolving situation in the Middle East has seen the latest ECB staff projections shift since their last publication in March. Growth expectations were revised lower in 2026 and 2027, to 0.8% (from 0.9%) and 1.2% (from 1.3%), respectively. The downgrades were marginal, and the ECB staff held short of calling for a contraction. Meanwhile, inflation forecasts for 2026 and 2027 were revised meaningfully upward to 3% (from 2.6%) and 2.3% (from 2%), respectively, underscoring the ECB’s view that higher energy prices should push inflation higher over the summer, keeping it above target through mid-2027. 

In light of the considerable uncertainty surrounding the outlook of the Middle East conflict, the ECB has also added a new alternate scenario that is more symmetric to the range of risks around its baseline. This new milder scenario sees oil prices normalize more rapidly, implying inflation would fall below target in 2027 and 2028 while growth would recover earlier and more robustly. 

The ECB’s decision makes it the first of the major central banks to hike, reflecting the euro area’s acute exposure to energy-driven inflation. Indeed, today’s unanimous decision was supported by the evolving data, and according to Lagarde was weighed against a range of alternative scenarios ECB staff has laid out.

While today’s move was fully priced in, the future path is less clear and remains highly dependent on the duration of the Middle East conflict. As it stands, the combination of higher inflation projections and only marginal growth downgrades indicates the ECB must have a clear bias toward addressing inflation risks. While the ECB has retained optionality, the projections point away from a one-and-done move. We expect further tightening as policymakers seek to contain the inflation shock, even if that requires sacrificing some growth in the near-term.