The European Central Bank is widely expected to deliver another interest rate hike on September 10, with markets pricing in a 25-basis-point increase that would lift the deposit facility rate from 2.25% to 2.5% — marking the second hike this year.

The move comes as eurozone inflation has once again breached the 3% threshold, but the renewed price pressure is being driven almost entirely by surging energy costs, which has created a difficult dilemma for policymakers. Unlike demand-driven inflation, an energy supply shock is largely beyond the reach of monetary policy, raising questions about what higher rates can actually achieve in the current environment.

The renewed inflationary pressure stems from escalating tensions in the Middle East, which have disrupted military, shipping, and energy infrastructure since late August. This has pushed international oil and gas prices sharply higher, with eurozone energy inflation jumping from 10.3% in July to 14.3% in August — the primary driver behind the overall inflation rate climbing from 2.9% to 3.3%, its highest level since September 2023.

For the eurozone, which relies heavily on energy imports, rising energy costs directly impact household living expenses while simultaneously increasing production and transportation costs for businesses. The ECB's previous rate hike in June — its first in three years — was similarly a response to energy price shocks, though the bank paused in July before the current wave of price increases reignited expectations for September action.

Inflation Not Broad-Based

While the headline inflation figure of 3.3% might suggest a clear case for continued tightening, a closer examination of the inflation structure reveals a more nuanced picture. Core inflation, which excludes energy, food, alcohol, and tobacco, actually declined from 2.5% to 2.4% in August, while services inflation — more closely tied to wages and domestic demand — eased from 3.3% to 3%.

This suggests that the so-called "second-round effects" have yet to materialize, meaning energy cost increases have not yet cascaded into broader goods and services prices or triggered a wage-price spiral. ECB economists have noted that geopolitical tensions accounted for approximately 90% of energy inflation between January and May of this year, with supply factors dominating while demand-side and public policy stimulus played a smaller role.

This distinguishes the current situation from the 2021-2022 inflation surge, which was driven by an unprecedented combination of both supply and demand factors and warranted the forceful, sustained rate hikes implemented at that time. The current supply-driven shock presents a different challenge entirely.

Divergent inflation rates across eurozone member states further underscore the uneven nature of the current price pressures. In August, Spain recorded 4.5% inflation, Germany 2.9%, and France 2.7% — three economies facing identical energy shocks yet producing markedly different outcomes, all while being subject to the same interest rate policy. This disparity highlights the fundamental tension of the upcoming decision: if inflation stems from overheated demand, higher rates can cool consumption, investment, and credit; but if it's driven by energy supply constraints, rate hikes do little to address oil and gas prices while potentially suppressing economic growth through higher financing costs.

Room for Further Tightening

The ECB's willingness to raise rates also reflects the eurozone's surprising economic resilience. Despite higher energy costs and drought-related disruptions, the economy has performed better than anticipated, with bank lending even accelerating in July — a sign that the June hike has yet to weigh heavily on economic activity. This gives policymakers latitude to tighten further without immediately choking off growth.

ING suggests the eurozone economy has shown unexpected robustness, partly due to fortune and partly because Asian competitors have been harder hit by disruptions to the Strait of Hormuz, with fiscal stimulus also playing a supporting role. However, ING cautions that resilience doesn't guarantee continued growth or acceleration, describing the expected hike as "another insurance rate hike" or a "dovish rate hike" — noting that even at 2.5%, the deposit facility rate remains within what the ECB itself considers the neutral range.

The real policy significance lies in whether the ECB signals additional tightening ahead. If the bank views this hike purely as a precautionary measure against energy price shocks, 2.5% might represent a near-term peak. However, if policymakers believe inflation is broadening beyond energy into other sectors, further hikes in October and December cannot be ruled out — a scenario that would indicate the bank views the economy as needing restrictive monetary policy, representing a fundamentally different assessment.

Markets currently price in two to three additional rate hikes by end of next year, but that expectation remains contingent on inflation and growth data. With Brent crude already touching $100 per barrel, the risk to inflation is clearly tilted to the upside. Lorenzo Codogno, founder of LC Macro Advisors, warns that rising fuel costs, trade tensions, and weather-related supply disruptions are creating conditions for a new round of inflation, which could force the ECB to act again in October and December. "We may now be at an inflection point for inflation, with wage pressures likely to emerge at some point," Codogno said.

Meanwhile, financial conditions have already tightened meaningfully. Long-term bond yields are hovering near levels not seen since before the global financial crisis, reflecting both inflation concerns and rising government debt across European nations. Additional supply pressure comes from large technology companies issuing bonds to fund AI investment booms, as well as Germany's domestic political situation. The impact of Thursday's decision could therefore extend well beyond the 25-basis-point move itself, as any signals of future tightening could push bond yields and corporate financing costs even higher, amplifying the effect on economic activity.

Global Central Bank Context

The ECB's decision comes against a backdrop of repricing across major global central banks, making currency dynamics a crucial external variable. The Federal Reserve's meeting on September 15-16 takes on added significance, with Fed Chair Kevin Warsh signaling at this year's Jackson Hole symposium that U.S. financial conditions are not restrictive and underlying inflation has not shown meaningful improvement. Market pricing now suggests a 60% probability of a rate hike from 3.5%-3.75% to 3.75%-4%, a significant shift from the roughly one-third probability priced in before Warsh's hawkish remarks.

The Bank of Japan, meeting September 17-18, has an 80-90% probability of raising rates to 1.25% priced in by markets, while the Bank of England is expected to hold at 3.75% on September 17. This synchronized global tightening means the ECB's action is not isolated, with changes in major central bank policy paths affecting the eurozone through capital flows and exchange rates.

Particularly noteworthy is the euro's trajectory. If the Fed hikes while the ECB remains on hold, the interest rate differential could widen, pushing the dollar stronger against the euro. For the ECB, euro depreciation presents a double-edged sword: while a weaker currency boosts export competitiveness, it also raises import costs — and with international oil and gas priced in dollars, a softer euro means European energy imports become more expensive in local currency terms. With eurozone inflation already back above 3% and energy prices serving as the primary driver, exchange rate movements could generate fresh imported inflationary pressures — adding yet another layer of complexity to an already challenging policy environment.