ECB raises interest rates to 2.25% in first hike since 2023 as Iran war fuels inflation

Rate decision

The European Central Bank increased its three main interest rates by 25 basis points, pushing the deposit facility rate to 2.25%, the main refinancing rate to 2.40%, and the marginal lending facility to 2.65%. The decision, widely anticipated by analysts, marks the first tightening move since the ECB ended its previous hiking cycle in September 2023. It is also the first time a major central bank has raised rates in direct response to the Middle East conflict, according to market sources.

The Governing Council will raise rates by 25 basis points as inflationary pressures mount, given that there is no end in sight to the Gulf conflict.

The Governing Council said it was committed to ensuring inflation returns to the 2% target over the medium term and that the rate increase was appropriate across a range of scenarios for how the shock might evolve.

Inflation outlook

Eurozone headline inflation accelerated to 3.2% in May, well above the ECB’s target, driven mainly by surging energy prices after the Iran war closed the Strait of Hormuz. The ECB’s new staff projections, released alongside the rate decision, show headline inflation averaging 3.0% in 2026, up from a March forecast of 2.6%, before easing to 2.3% in 2027 and 2.0% in 2028. Core inflation, which excludes energy and food, is seen at 2.5% in both 2026 and 2027, dropping to 2.2% in 2028.

The upward revision reflects higher energy costs spilling over into food, goods and services prices, the ECB noted. With the Strait of Hormuz still blocked and diplomatic efforts showing little progress, economists see a real risk of further inflation acceleration.

Growth downgraded

In parallel, the growth outlook deteriorated. The ECB now expects GDP to expand by just 0.8% in 2026, down from the previous 0.9%, followed by 1.2% in 2027 and 1.5% in 2028. The downgrade mirrors the hit from commodity-market disruption, weaker real incomes and sagging confidence, raising concerns of stagflation in the 20-nation bloc.

The May business activity surveys had already pointed to falling output, prompting questions about how far borrowing costs could rise without tipping the economy into recession.

Analysts brace for further hikes

Market participants do not view Thursday’s move as a one-off. Several economists polled by Greek media expect at least one additional rate increase later this year, which would lift the deposit rate to 2.50% by end-2026. The ECB’s own communication will be scrutinised when President Christine Lagarde holds her press conference; investors will search for clues on the bank’s reaction function.

They have reached a nearly unanimous agreement on the first rate increase since September 2023, wanting to avoid repeating the mistake of 2022, even at the risk of excessively slowing the economy.

The reference is to the 2021–2022 period, when the ECB dismissed rising prices as transitory, only to be forced into rapid tightening later.

The monetary policy pivot

By acting now, the ECB becomes the first major central bank to acknowledge that inflation risks from the Iran war are real and worrying, analysts say. The decision signals a shift from a wait-and-see approach to pre-emptive tightening, even though the economic backdrop is fragile. The Governing Council stressed it will remain data-dependent, but its quarterly projections make clear that monetary policy may need to stay restrictive well into 2028.