European Central Bank hikes interest rates to 2.5% as policymakers see risk of higher inflation, weaker growth

The European Central Bank has voted to raise its key deposit rate by 25 basis points to 2.5% from 2.25% in a move widely expected by investors.

But uncertainty around the U.S.-Iran war continues to cloud the outlook for the ECB's longer-term policy path, market watchers say, and investors will be watching closely for signals in policymakers' remarks later on Thursday.

The ECB expects baseline inflation, excluding energy and food, to reach 2.5% in 2026, 2.6% in 2027 and 2.3% in 2028.

"The outlook remains highly uncertain, with risks to the upside for inflation and to the downside for economic growth," the ECB's Governing Council said, acknowledging a "broad range of outcomes" around growth and inflation as a result of the energy shock, including duration and second-round effects.

Markets priced in a 100% chance of the 25 basis points hike ahead of Thursday's meeting, according to LSEG data.

ECB officials have said since the U.S.-Iran war broke out that they would take a meeting-by-meeting approach to monetary policy. The central bank's rates-setting Governing Council will hold a press conference in Berlin, scheduled for 8:45 a.m. E.T., following the decision.

The move comes days after data showed inflation in the euro zone hit 3.3% in August, with energy inflation surging to 14.3%.

The euro zone, a net importer of energy, has seen inflation above the ECB's 2% target since the war in the Middle East threatened commodity transit through the Strait of Hormuz, causing oil prices to spike and remain volatile.

Government borrowing costs have also risen drastically in recent weeks, with European bond yields hitting multi-decade highs as intensifying conflict in the Middle East led investors to price in higher inflation and rate hikes.

Euro zone 10-year government bond yields

Investment strategists said the decision indicates further rate rises are now likely.

Ed Hutchings, head of rates at Aviva Investors, said the outlook for inflation remains a "significant source of concern" for the Governing Council and investors alike.

"It's clear more hikes will be coming, and potentially more than one," Hutchings said. "The immediate priority for the ECB is clear: address the inflationary backdrop, and, as such, the market is right in thinking more hikes will be coming. However, with two hikes already being delivered and more than a further two hikes priced, things may well have gone too far."  

Patrick Ernst, macro investment strategist, JP Morgan Private Bank, said the rates trajectory now hinges on the uncertain geopolitical backdrop.

"In keeping the door open to further tightening, policymakers made clear that an energy-led inflation risk is still very much in play," Ernst said. "One hike is not a ceiling."

Felix Feather, economist at Aberdeen, said he expects another hike at the ECB's December meeting.

"The eurozone has proved remarkably resilient despite higher energy prices and geopolitical uncertainty, leading policymakers to revise growth expectations higher," Feather said. "At the same time, inflation forecasts have also moved up, reflecting elevated energy costs and concerns that inflation could remain above target for longer."

The ECB raised rates in June for the first time since 2023, bringing its key interest rate to 2.25% and making it the first major central bank to enact a hike in response to the war.

ECB President Christine Lagarde said at the time that there were upside risks for inflation and downside risks for economic growth, but she stressed that policymakers are "not pre-committing to a particular rate path."

The ECB held interest rates steady at its subsequent meeting, with its Governing Council saying it was "closely monitoring the intensity and duration of the [energy] shock, as well as its indirect and second-round effects."

Uncertainty around the ECB's rate path has divided investors: a survey by Deutsche Bank of its clients over the past week showed no consensus about where Thursday's decision would sit in the central bank's hiking cycle.

Deutsche Bank economists said in a note on Tuesday that more than a third of respondents agreed with their view that the ECB would take its key rate to a peak of 2.75%. One in four say the ECB will hold rates at 2.5%.

Another quarter of respondents saw the cycle ending with a 3% terminal rate, suggesting two more hikes before the ECB's tightening cycle is through.