The European Central Bank's decision to raise interest rates by a quarter point on Thursday reflects a stark reality: Europe is caught between soaring energy prices and the need to prevent that shock from embedding itself into the economy. The deposit rate now stands at 2.5%, the second increase in three months, and the move was driven by pressures visible at every petrol station and in every household bill.
Brent crude has climbed back above $100 a barrel as tensions in the Middle East disrupt shipping through the Strait of Hormuz. Natural gas prices have been even more volatile, with the Dutch TTF benchmark—the reference for European gas—up nearly 190% since the start of the year. Eurozone inflation accelerated to 3.3% in August, with energy prices rising 14.3% year-on-year, up from 10.3% in July.
The central bank's tools, however, cannot produce a single barrel of oil or a cubic metre of gas. So what does a higher deposit rate actually achieve? The answer lies in the bank's attempt to cool domestic demand, preventing an imported price shock from turning into a self-sustaining cycle of wage and price increases.
What higher rates can and cannot do
ECB President Christine Lagarde described the decision as a "no-brainer," pointing to the Middle East conflict as a persistent source of inflationary pressure. "Inflation is set to remain well above target for an extended period," she said. Yet a central bank cannot reopen a shipping lane or refill gas storage before winter. What it can do is dampen demand at home, so that the energy shock does not become a domestic one.
So far, the evidence suggests that the shock has not yet made that jump. Core inflation, which excludes energy, food, alcohol, and tobacco, edged down to 2.4% in August. Services inflation, a key gauge of domestic overheating, eased to 3.0% from 3.3%. "Wages do not show a material response to the energy shock at this stage," Lagarde noted.
The ECB is not reacting to what has already happened; it is responding to what it fears might come next. "While more restrictive monetary policy is not an effective response to short-term, supply-driven inflation shocks, the ECB is moving in this direction to combat inflation that is becoming more structural," said Joe Nellis, emeritus professor and head of economic research at MHA.
What began as a war premium on crude has now persisted long enough to seep into contracts, transport costs, insurance, and household expectations. The bank's own forecasts show inflation remaining above target for years, with 2027 and 2028 projections revised upward to 2.5% and 2.1% respectively.
The real target: expectations
"The energy shock could intensify further, and its effect on other prices and wages could be stronger than currently expected," Lagarde warned, adding that gas prices could spike again if supply disruptions worsen or a cold winter depletes storage. The ECB's wage tracker already shows negotiated wage growth ticking up to 2.7% in the first half of 2027—a sign that expectations are beginning to shift.
If workers expect prices to keep rising and employers believe they can pass on costs, the oil shock stops being a mere shock and becomes an inflation regime. "Inflation should remain well above target into next year, as higher gas and food prices put additional upward pressure on the index," said Leo Barincou, senior economist at Oxford Economics.
Could rates hit 3%?
Perhaps the most telling part of Thursday's announcement was what Lagarde did not say. She declined to push back against market pricing for further tightening, noting only that the council had not debated the path ahead and that markets were doing "their job." Economists took that silence as a hawkish signal.
"We now think the ECB will shift its policy rate more decisively into restrictive territory over the next six months, with a rate hike in December followed by another in February, taking the deposit rate to 3.00%," said Claus Vistesen, chief eurozone economist at Pantheon Macroeconomics. Oliver Rakau, chief Germany economist at Oxford Economics, agreed: "The bigger takeaway from today was how low the bar to further tightening is."
Can Europe afford the squeeze?
The cost of preventing persistent inflation is that higher rates also restrain an economy already burdened by expensive energy. Further hikes could squeeze indebted households, weaken housing markets, and make business investment more costly. Small companies may delay or abandon projects as financing costs rise.
Yet the ECB has upgraded its growth outlook for this year and next, thanks to technology-related business activity and German fiscal support. That gives policymakers some room to act, though it does not eliminate the pressure on borrowers. The question is not simply whether the ECB raises rates again, but how long higher rates remain necessary. Monetary policy can limit inflation's spread, but whether it succeeds without damaging growth will depend heavily on how quickly Europe's energy pressures ease.
As Europe navigates this delicate balance, the ECB's recent moves are being closely watched. Meanwhile, the EU's energy independence plan faces its own hurdles, and climate leaders urge faster action on clean energy. The path ahead is uncertain, but the ECB's resolve is clear.
