ECB hikes interest rates for first time since 2023 as Iran war ramps up energy costs

The European Central Bank announced a quarter-point rate hike on Thursday, bringing its key interest rate to 2.25% as the Iran war continues to blow inflation off target.

Markets had been pricing in a near-100% chance of the ECB raising rates by at least 25 basis points ahead of its June Governing Council meeting, according to LSEG data.

The ECB's Governing Council said the decision had been made in a bid to ward off inflationary pressures generated by the U.S.-Iran war.

"The war in the Middle East is generating inflation pressures, and the decision to raise rates is robust across a range of scenarios mapping out how the shock might evolve and affect the medium-term outlook for the euro area," it said in a statement announcing the decision.

The central bank also raised its inflation forecasts, saying it now expects headline inflation in the euro zone to average 3% in 2026 before cooling to 2.3% next year and 2% in 2028.

It said the outlook had been altered in response to expectations of higher energy prices, which are expected to feed into the cost of food, goods and services.

Economic growth forecasts, meanwhile, were revised downward for this year and next year. The ECB now expects growth in the euro zone to average at 0.8% in 2026, 1.2% in 2027 and 1.5% in 2028.

Officials said the growth outlook had been trimmed to reflect "a more pronounced impact of the war on commodity markets, real incomes and confidence."

Speaking to reporters on Thursday afternoon, ECB President Christine Lagarde reiterated that the war in the Middle East is generating inflation pressures.

"The outlook remains uncertain, with upside risks for inflation, and downside risks for economic growth. We are not pre-committing to a particular rate path," she said.

"The full implications of the war for 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 and second-round effects."

The Iran war — which recently crossed the 100-day mark — has caused a global energy price shock, as the closure of the Strait of Hormuz waterway and destruction of energy production facilities in the Middle East have created severe supply constraints. A fragile ceasefire remains in place, but tensions have escalated between Washington and Tehran in recent days.

The ECB said Thursday that its Governing Council "remains well positioned to navigate the uncertainty caused by the war," and will closely monitor the situation — but it stressed that officials are "not pre-committing to a particular rate path."

Euro zone inflation rose to 3.2% in May, flash data showed earlier this month, as higher energy costs drove the region's inflation rate further above the ECB's 2% target.

The euro zone economy grew by just 0.1% in the first quarter of the year.

Mark Wall, chief European economist at Deutsche Bank, said the ECB hike was "a significant moment."

"Not only is this the first ECB hike since 2023, it is also the first hike by one of the major global central banks in response to the energy shock," he said in a note. "The ECB is saying that a 'look through' strategy is not a robust response. The question is how far can this tightening cycle go? Not far, is our answer. There is upside risk to inflation, but there is also downside risk to growth. One more hike in September and that's it."

Neil Birrell, chief investment officer at Premier Miton, said in a note following the ECB's announcement on Thursday that the decision was unsurprising given the inflation backdrop.

"Encouragingly, they don't see much risk to GDP, although growth expectations are already muted," he said. "This is likely to be followed by more rate hikes this year, depending on the data, but it's hard to think this is the end of the policy move."

The yield on the 10-year German bund, seen as a benchmark for the euro zone, was 2 basis points lower by 2:50 p.m. in Frankfurt. The euro was flat against the dollar and the British pound.