ECB raises key interest rate: The reasons behind the rate hike

The European Central Bank raised its key interest rate from 2.0% to 2.25% yesterday, Thursday. In doing so, the central bank sent a confidence-building signal of its commitment to bringing inflation back to its 2% target in the medium term.

Because numerous council members had signaled the interest rate hike in their speeches (i.e., forward guidance), the move comes as no surprise, and the market reaction has been correspondingly muted.

Dovish or hawkish?

The interest rate hike sends a restrictive signal. Central banks are always faced with a trade-off. Should the key interest rate be kept relatively low to support the economy and the labor market and/or to keep interest payments on government debt low? This policy is referred to as “dovish” and tends to push inflation higher.

Or should the key interest rate be kept relatively high in order to keep inflation low enough that rising prices do not become the focus of attention? This policy is referred to as “hawkish” and tends to lead to falling inflation.

In fact, consumer price inflation has risen in recent months. In February, the year-over-year price increase was 1.9%. By May, it had risen to 3.2%. However, this acceleration in price growth was not broad-based. The driving factor is easy to identify. The change in energy prices jumped from minus 3.1% to plus 10.9%. Excluding energy prices, inflation remained largely unchanged at 2.4%.

At the same time, economic activity has been sluggish since the start of the year. In the first quarter, gross domestic product grew by just 0.3% year-over-year. Employment growth was similarly sluggish (0.5% year-over-year).

Why is the ECB raising rates now?

This raises the question of why the central bank is raising the key interest rate at all. The rise in inflation was not caused by a booming economy, but was triggered by the de facto closure of the Strait of Hormuz. The central bank has no control over energy price trends. Wouldn’t it then be wiser to “see through” this? If energy prices fall, won’t inflation then return to where it was before?

The context is key. Inflation has now been above the 2% target since 2021. Although inflation was already well on its way to stabilizing at the central bank’s target of around 2%, the energy price shock triggered by the Iran crisis has led to another rise in inflation. Against this backdrop, the risk has increased that long-term inflation expectations among all of us will rise permanently.

If everyone expects inflation to rise and acts accordingly (companies raise prices, workers demand wage increases), then inflation will actually rise. If such a scenario were to occur, only massive interest rate hikes—which would likely trigger a recession—could bring inflation back down. To counteract such a development, the ECB prefers to raise key interest rates slightly at an early stage—in the hope of avoiding the need for sharp hikes at a later date.

The effects of rising energy prices are clearly stagflationary. They drive up inflation and slow economic growth. The ECB shares this view. Inflation forecasts have been revised upward (2026: 3.0%, 2027: 2.3%, 2028: 2.0%). According to the ECB, this is due not only to higher energy prices but also to expected pass-through effects on food, goods, and service prices. Accordingly, growth forecasts have been revised downward due to the decline in purchasing power (2026: 0.8%, 2027: 1.2%, 2028: 1.5%). This is because purchasing power is being reduced.

What are the central bank’s next steps?

At the press conference, ECB President Lagarde noted that the outlook remains uncertain, with upside risks to inflation and downside risks to economic growth.

The rate hike is unlikely to mark the start of a rate-hiking cycle because economic growth is not strong (unlike in the U.S.). If the impact of energy prices subsides as the Strait of Hormuz reopens, the spillover effects from energy prices to other prices remain low, and inflation expectations do not rise, the key interest rate is unlikely to be raised this year by more than is currently reflected in market prices (one additional rate hike).

Hopefully, these small interest rate adjustments will be enough to keep inflation expectations stable. This would mean that the negative impact on economic growth and the stock markets would be relatively minor.

 

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