The European Central Bank has raised interest rates by 25 basis points in its first hike since 2023, hitting borrowers across the Eurozone, but officials warn that the timing and scale of future moves remain completely up in the air.
ECB President Christine Lagarde indicated that everything depends on the duration and intensity of the war in Iran. She said that uncertainty is so high that the Governing Council will make decisions step-by-step and meeting by meeting.
European officials familiar with the discussions in Frankfurt said that the central bank is weighing two main tracks for its interest rate policy based on conflict models.
The first track assumes a prolonged war that continues to disrupt shipping through the Strait of Hormuz. Under an adverse scenario of extended hostilities between the US and Iran, the ECB projects inflation will shoot up to 4% this year and 5.3% in 2027, before dropping to 3% in 2028. Under its baseline scenario of a shorter conflict, Eurozone inflation should hit 3% this year, 2.3% in 2027, and 2% in 2028.
The duration of the war will determine where inflation lands between these baseline and worst-case figures, directly dictating the pace and scale of interest rate hikes over the coming months. Based on these models, the ECB will likely raise rates by another 25 basis points in September, with another increase potentially following toward the end of the year.
The second track focuses on a positive outcome where the war ends relatively quickly. However, officials warn that a swift end to the conflict will not immediately erase the supply chain inflation caused by the energy shock of closing the Strait of Hormuz. Forecasters estimate that it will take several months for supply chains to normalise and for prices to return to pre-crisis levels.
Consequently, current inflationary pressures mean the ECB might still raise interest rates in September. However, credible sources said that if inflation risks are seen to be fading, the ECB will not hesitate to cut interest rates even before the end of the year, reversing the current hikes.
Lagarde kept all options open during her press conference, stating that the central bank is not committing to a particular interest rate path. This opens the door for potential rate cuts later this year, even after initial hikes, if inflation falls back toward the 2% target.
The ECB is also tracking economic growth risks exacerbated by the situation in Iran and a broader tariff war. The ECB’s adverse scenario shows Eurozone growth slowing to 0.5% this year compared to 0.8% in the baseline model. For 2027, growth could tumble to 0.4% compared to 1.2% in the baseline, before recovering to 1.6% in 2028 compared to 1.5% in the baseline.
Informed sources said that even if inflation returns to the 2% target, further interest rate cuts cannot be ruled out if the central bank identifies an overriding risk of deflation and weaker economic growth across the Eurozone.