Europe is facing a squeeze from two directions: more expensive energy and higher borrowing costs intended to contain the inflation that the same energy shock created.
The European Central Bank raised its key three interest rates by 0.25% on Thursday, bringing the deposit rate to 2.5%.
It is the second rate hike in three months, and the reason is visible on every forecourt in Europe.
Brent crude climbed back above $100 a barrel on Wednesday as the conflict between the United States and Iran continued to disrupt traffic through the Strait of Hormuz.
The pressure is arguably sharper in gas, where the Dutch TTF benchmark, the reference price for the European market, has rallied by 190% since the start of the year.
Eurozone inflation accelerated to 3.3% in August from 2.9% in July, with energy prices rising 14.3% over the year against 10.3% a month earlier.
Which raises the question that hangs over the whole decision.
Interest rates do not produce barrels of oil or cubic metres of gas. So what exactly is a higher deposit rate meant to achieve?
What higher rates can and cannot reach
Christine Lagarde described the decision as a “no-brainer”.
In her press conference she said that “the conflict in the Middle East continues to generate inflation pressures, and inflation is set to remain well above target for an extended period.”
A central bank cannot reopen a shipping lane. It cannot refill a gas storage facility before winter.
What it can do is cool demand at home, so that an imported price shock does not turn into a domestic one. The evidence so far suggests the shock has not yet made that jump.
Core inflation, which strips out energy, food, alcohol and tobacco, actually edged down in August to 2.4% from 2.5%.
Services inflation, the measure the ECB watches most closely for signs of domestic overheating, eased to 3.0% from 3.3%.
“Wages do not show a material response to the energy shock at this stage,” Lagarde said.
The ECB is not responding to what has happened. It is responding to what it fears will happen next.
“While more restrictive monetary policy is not an effective response to short term, supply driven inflation shocks, the ECB is moving in this direction to combat inflation that is becoming more structural,” Emeritus Professor Joe Nellis, head of economic research at the accountancy and advisory firm MHA, said in a note.
What began in the spring as a war premium on crude has now lasted long enough to work its way into contracts, transport costs, insurance and household expectations.
The real target is expectations
Headline inflation is still seen at 3.0% this year, but the forecasts for 2027 and 2028 were both revised upwards, to 2.5% and 2.1% respectively.
Neither headline nor core inflation returns cleanly to 2% by the end of the horizon.
“The energy shock could intensify further, and its effect on other prices and wages could be stronger than currently expected,” Lagarde said, adding that “gas prices, in particular, could increase in the event of further supply disruptions or an unusually cold winter coinciding with low storage levels.”
The ECB’s own wage tracker already points to negotiated wage growth ticking up to 2.7% in the first half of 2027.
That is the mechanism the Bank is trying to interrupt. If workers expect prices to keep rising and employers expect to be able to pass costs on, the oil shock stops being an oil shock and becomes an inflation regime.
“Inflation should remain well above target into next year, as higher gas and food prices put additional upward pressure on the index,” said Leo Barincou, senior economist at Oxford Economics.
Could ECB interest rates hit 3%?
The most consequential part of Thursday was arguably what Lagarde did not say.
She declined to push back against market pricing for further tightening, noting only that the council had not debated the path ahead and that markets were doing “their job” while the ECB did its own.
Claus Vistesen, chief eurozone economist at Pantheon Macroeconomics, treated that silence as a hawkish signal.
“We now think the ECB will shift its policy rate more decisively into restrictive territory over the next six months, with a rate hike in December followed by another in February, taking the deposit rate to 3.00%,” he said.
Oliver Rakau, chief Germany economist at Oxford Economics, drew a similar conclusion.
“The bigger take away from today was how low the bar to further tightening is,” he wrote, while noting that “contained underlying inflation pressures continue to favour a reactive or data dependent approach to policy setting from the ECB”.
Can Europe afford the squeeze?
The cost of preventing persistent inflation is that higher rates also restrain activity already burdened by expensive energy.
Further interest rate increases could squeeze indebted households, weaken housing markets and make business investment more expensive.
Small companies could delay or abandon projects as financing costs rise.
Yet, the ECB has upgraded its growth outlook for this year and next.
Technology-related business activity and German fiscal support offer positive impacts on growth. That gives policymakers room to act, although it does not eliminate the pressure on borrowers.
The question is therefore not simply whether the ECB raises rates again, but how long higher rates remain necessary. Monetary policy can limit inflation’s spread.
Whether it succeeds without damaging growth will depend heavily on how quickly Europe’s energy pressures ease.