ECB lifts rates to 2.5% and flags Iran war as a fresh inflation driver

The European Central Bank (ECB) pushed its main interest rate to 2.5% on Thursday and told markets that price pressures across the eurozone are likely to continue for longer. The bank blamed renewed fighting between the US and Iran for a jump in energy costs that is now feeding into the wider economy.

25 basis point move markets saw coming

The increase, from 2.25%, was widely anticipated by investors, according to the Guardian. However, the language surrounding the increase was the rather unsettling part. The ECB’s accompanying report warned of inflation building across many parts of the economy, and ECB president Christine Lagarde told reporters in Berlin that she believes “inflation will be longer lasting than we had anticipated.”

The new ECB rate is the highest the euro bloc has seen since March of last year. The ECB has also increased its 2026 eurozone growth forecast from the 0.8% it projected in June to 0.9%. The central bank now expects inflation to average 3% across the year, a figure that sits well above the bank’s stated 2% target, reaffirmed in its policy materials released today.

Lagarde gave a rough timeline for relief from the current situation. “Headline inflation is expected to return to around target towards the end of 2027, supported by the effects of higher interest rates,” she stated.

Energy continues to wreak havoc

Attacks by the US and Iran on shipping through the Strait of Hormuz this week sent crude even higher, with Brent pushing past $105 a barrel before easing to about $104.5, a gain of about 3.3% on the day.

The Dutch wholesale price for gas, which is the EU’s benchmark, went above €80 per megawatt hour for the first time since January 2023 and traded 3.4% higher at €82.56/MWh. In Britain, gas hit 203 pence per therm, a level unseen since December 2022.

The ECB president noted that food inflation, still low at 1.2%, is likely to see an increase as higher oil and gas prices work their way through supply chains. Central bankers worry the same pressure will lift transport costs and heating bills for homes and businesses alike, turning an energy shock into a general one for the economy.

EU gas stores are only 67% full against a five-year average of 84%, according to the Guardian, because buyers held off filling tanks in the hope the Middle East conflict would ease before winter. If it does not, a late scramble for supply could lead to even higher prices.

Bond markets in the red

Government borrowing costs have surged a lot recently, and the rate hike is coming alongside. The yield on 10-year UK gilts hit 5.36%, the highest since August 2007, representing a 19-year peak.

Germany’s 30-year bond rose to 5.08%, the most since December 2003, while its 10-year yield reached 3.45%, a level last seen in April 2011. France’s 10-year yield hit 4.344%, the highest since October 2008.

The strain has also hit Washington, with US Treasury Secretary Scott Bessent stating that the government would buy back $6 billion of treasuries to ease a sell-off pressuring US rates. Bond buyers, however, judged the package too small, and the 10-year treasury yield subsequently climbed to a three-year high.