The European Central Bank delivered its second interest rate hike of the year on Thursday, lifting all three key rates by 25 basis points. The deposit facility rate rose to 2.50%, while the main refinancing operations rate and marginal lending facility rate climbed to 2.65% and 2.90% respectively, with the new rates taking effect from September 16. The move aligned with market expectations.
At the post-decision press conference, ECB President Christine Lagarde highlighted that risks to the inflation outlook remain tilted to the upside, stemming from developments in the Middle East conflict and the Russia-Ukraine situation, where energy shocks could intensify further. Their impact on other prices and wages may also prove stronger than currently anticipated. She specifically flagged the winter gas risk: prices could surge if new supply disruptions emerge, or if an unusually cold winter combines with low inventory levels.
In its policy statement, the Governing Council noted that the Middle East conflict continues to generate inflationary pressures, with inflation set to remain significantly above target for an extended period. The decision underscores the Council's commitment to ensuring inflation stabilises at 2% over the medium term. This marks the ECB's second hike this year, following an initial increase in June that brought the key rate to 2.25% 鈥?the first major central bank to tighten policy in response to the war. The July meeting saw rates held steady.
Updated projections accompanying the decision show headline inflation averaging 3.0% in 2026, 2.5% in 2027, and 2.1% in 2028, while core inflation (excluding energy and food) is seen at 2.5%, 2.6%, and 2.3% respectively. Compared with June forecasts, 2026 projections were unchanged, while 2027 and 2028 were revised upward. On growth, the ECB raised its 2026 forecast from 0.8% to 0.9%, with 2027 and 2028 projected at 1.4% and 1.5% respectively 鈥?the 2027 figure also revised up from June, reflecting stronger-than-expected resilience in the euro area economy.
The bank emphasised that the outlook remains highly uncertain, with inflation risks tilted to the upside and growth risks to the downside. Staff scenario analysis shows a wide range of outcomes for both growth and inflation under different assumptions about the intensity, duration, and indirect effects of energy shocks. The policy guidance remained unchanged: the Governing Council will determine the appropriate policy stance meeting-by-meeting based on incoming data, with no pre-commitment to a specific rate path.
The rate decision came against a backdrop of surging energy prices. Euro area inflation stood at 3.3% in August, with energy inflation jumping to 14.3%. As a net energy importer, the euro zone has seen inflation persistently above the 2% target since Middle East hostilities threatened shipping through the Strait of Hormuz, driving oil prices higher and amplifying volatility. Brent crude broke above $100 per barrel for the first time since July in the session before the decision, and jumped another 4% on Thursday to briefly touch $105, following the largest escalation in attacks on shipping since the war began.
Lagarde indicated that headline inflation is expected to return to target around the end of 2027, supported by the effects of rate increases. She noted that shorter-term inflation expectations remain elevated, but most longer-term indicators are still anchored around 2%. Most underlying inflation measures were broadly stable in July, with no substantial wage response to the energy shock yet observed. The ECB's wage tracker shows negotiated wage growth edging up to 2.7% in the first half of 2027. On the economy, she struck a cautiously optimistic tone: despite headwinds from the energy shock, the second quarter showed resilience, with growth broad-based across countries and sectors, a trend likely to extend into the third quarter.
Market participants remain divided on the ECB's rate trajectory. Felix Feather, economist at Aberdeen, noted before the decision that the hike itself was a foregone conclusion, with the key question being whether the language signals this is a step in a longer tightening cycle, given the euro area's economy has proven more resilient than the ECB expected. A Deutsche Bank survey of clients revealed no consensus on the peak rate: over a third agreed with the bank's call for rates to reach 2.75%, a quarter expect only one more hike, and another quarter anticipate a terminal rate of 3%.
The European bond sell-off intensified during the press conference, with prices falling further. Germany's two-year yield rose as much as 12 basis points to 3.19%, the highest in nearly three years. Swap markets have fully priced in three more 25-basis-point hikes by mid-next year, with the probability of another move at next month's meeting exceeding 50%. Longer-dated yields also pushed higher: by Thursday evening European time, Germany's 10-year yield gained 5.3 basis points to 3.512%, France's 10-year rose 10.7 basis points to 4.436%, and Italy's 10-year added 1.5 basis points to 4.292%.
The currency market reaction was choppy. The euro initially plunged against the dollar around the announcement, dipping to 1.1597 intraday, before recovering most of the losses during Lagarde's press conference to trade at 1.1622 by Thursday evening, down 0.12%. European equities also moved lower, with the benchmark Euro Stoxx 600 index falling 0.69% at the close, Germany's DAX down 0.84%, and France's CAC 40 losing 0.49%.
Fiona Cincotta, senior market analyst at StoneX, attributed the equity market pressure to the market interpreting the hike as hawkish, given the upwardly revised inflation forecasts and more resilient growth outlook.
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