ECB raises interest rates for first time in three years

FRANKFURT — The European Central Bank raised interest rates on Thursday for the first time in almost three years, becoming the first major central bank to respond to the inflationary fallout of the Iran war.

It was a necessary show of resolve against inflation. Or, it will come back to haunt the ECB if higher borrowing costs amplify the economic damage from a war-driven energy shock.

It depends who you listen to.

After its two-day monetary policy meeting ending Thursday, the ECB lifted its deposit rate by a quarter-point to 2.25 percent from 2 percent, arguing that rising oil and gas prices risk spilling into the broader economy and pushing inflation even further above its 2 percent target. In May, inflation jumped to 3.2 percent.

With fighting in the Middle East now in its fourth month, policymakers fear price pressures are becoming entrenched and won't be alleviated even if a diplomatic breakthrough eventually materializes. While declining to give explicit forward guidance, ECB President Christine Lagarde left the door open to further rate increases.

"The outlook remains uncertain, with upside risks for inflation and downside risks for economic growth," said Lagarde, warning that the conflict's impact will depend on the duration of the energy shock and whether it triggers wider second-round effects.

The ECB chief also pushed back against a narrative from certain analysts that the central bank is front-running developments in the real economy and delivering an "insurance hike" to bolster its inflation-fighting credentials.

“If we were not taking that very obvious monetary policy decision, then at the end of the medium term we would be north of our target,” she said

Still, the rate hike puts Frankfurt ahead of its global peers. The Bank of Canada held rates steady this week, while the Federal Reserve and the Bank of England are both expected to stay put next week.

By moving first, the ECB has positioned itself as the most hawkish of the world's major central banks. But whether that is remembered as leadership or as a replay of the ECB's ill-fated 2011 rate hikes will depend less on events in Frankfurt than on developments in the Middle East.

The decision drew praise from economists including Ifo President Clemens Fuest, who said raising rates was "the right step at this point" given high inflation and little hope of a de-escalation in the conflict with Iran.

ZEW economist Friedrich Heinemann also applauded the ECB’s move. "Faced with the trade-off between supporting growth and maintaining price stability, the Council is clearly siding with price stability. That deserves praise," he said.

Yet, others fear the ECB is repeating a familiar mistake by tightening policy in response to an external energy shock just as the economy weakens — echoing its rate hikes in 2011, when the ECB raised rates twice, only to be forced into a U-turn months later as the economy tanked.

“If the ECB were to go beyond the June hike, the eurozone may fare even worse with a risk that it could even fall into an unnecessary recession,” warned Berenberg Chief Economist Holger Schmieding after the press conference.

Lagarde also dismissed these concerns.

“The main risk would be not to take that kind of decision,” she asserted. “It's not as if we are in an environment where growth is absent or under significant threat,” she said, pointing to updated growth forecasts that see the economy expanding by 0.8 percent this year, 1.2 percent in 2027 and 1.5 percent in 2028.