ECB Holds Interest Rates, Warns of Inflation Risks from Middle East Hostilities

The European Central Bank voted on Thursday to leave its main interest rate unchanged at 2.25%, in a move that fell broadly in line with market expectations.

But traders are already anticipating a rate hike in September, as ECB president Christine Lagarde warned renewed Middle East hostilities and the resultant rebound in oil prices poses upside risk to the euro zone inflation outlook.

The ECB said it stands ready to adjust all of its interest rates to ensure that inflation stabilizes towards its 2% medium-term target. Eurozone inflation eased from to 2.8% last month from 3.2% in May.

In a press conference following the release, Lagarde said the bank anticipates inflation to remain "well above target" until the first half of 2027.

"Renewed disruption of energy supplies could increase energy prices further and for longer than expected," she told reporters.

"The longer energy prices stay high, the more likely they are to drive up broader inflation through indirect and second-round effects," Lagarde added.

Ed Hutchings, head of developed market rates at Aviva Investors, said traders now expect a 0.25% hike in September.

"Inflation expectations remain elevated and if sustained further, even tighter policy may well be needed," Hutchings said.

The hold comes after the ECB in June unveiled a quarter-point hike, its first rate rise since 2023, as inflationary pressures caused by the Iran war energy shock began to weigh on Europe's economy.

"Despite its ability to hold rates today, the market still expects the ECB to be in a rate raising mood for the rest of the year," said Richard Carter, head of fixed interest research at Quilter Cheviot.

"Clearly how aggressive it is in upping interest rates depends broadly on what is happening away from the continent, and that is making the job of the policy committee incredibly challenging."