The European Central Bank is moving toward another interest rate increase not because the euro zone economy is overheating, but because a prolonged energy shock is threatening to keep inflation above target for longer than policymakers had expected. According to economists surveyed in recent reporting, the ECB is widely expected to raise its deposit rate by 25 basis points in September to 2.50 percent, potentially ending one of its shortest tightening cycles in more than a decade.

The unusual feature of the expected move is that the ECB is confronting a supply shock rather than a conventional demand-driven inflation surge. The continuing United States-Iran conflict has kept oil prices substantially above pre-war levels, feeding directly into energy costs and indirectly into the prices of goods and services. The central bank cannot produce more oil or repair disrupted supply routes, but it can respond if the initial energy shock begins spreading through wages, business costs, inflation expectations and broader price-setting behaviour.

That is the reason the September decision has become increasingly important. The ECB paused in July after raising rates in June, but officials have stressed that the future path will depend on the persistence of the energy shock and its wider economic effects. Recent inflation data and revised forecasts have increased the pressure for another move, while stronger-than-expected economic growth has reduced the immediate argument for leaving monetary policy unchanged.

Energy prices are changing the ECB’s inflation calculation

The immediate trigger for the ECB’s renewed tightening bias is the persistence of higher energy prices. Euro zone inflation reached 2.9 percent in July, well above the central bank’s 2 percent target, after the energy shock caused by the conflict pushed inflation higher across several categories.

The ECB’s own assessment has been that the direct impact of energy prices would eventually fade, but the risk becomes greater the longer the shock continues. Higher fuel and electricity costs raise transportation and production expenses, increasing the cost of inputs for companies. Businesses can initially absorb part of those costs through lower margins, but prolonged pressure creates an incentive to pass them on to consumers.

That second stage is what policymakers are watching most closely. The central bank has repeatedly distinguished between the initial effect of higher energy prices and the so-called second-round effects that can spread through the wider economy. If companies repeatedly increase prices and workers respond by demanding higher wages, an external energy shock can become a more persistent domestic inflation problem.

Recent ECB assessments indicate that underlying inflation has remained more contained than headline inflation, but officials have warned that the full impact of the energy shock has not yet passed through the economy. That uncertainty makes waiting less attractive if policymakers believe inflation expectations or broader price-setting behaviour could begin shifting upward.

One more hike fits the ECB’s risk calculation

The expectation of a September increase also reflects the unusual sequence of the ECB’s recent policy decisions. The central bank raised rates in June and then paused in July, while maintaining a data-dependent approach. Economists now largely expect the September increase to be the final move, taking the deposit rate to 2.50 percent.

The logic is partly about credibility. If the ECB raises rates once in response to an energy shock and then stops immediately, markets could interpret the move as a temporary adjustment rather than a deliberate effort to prevent the shock from becoming embedded in inflation. A second increase would provide a clearer signal that policymakers are prepared to respond if price pressures remain persistent.

That does not mean the ECB is preparing for a prolonged series of aggressive hikes. The current expectation is that rates would remain around 2.50 percent well into 2027. The distinction is important because the central bank is attempting to prevent a temporary supply shock from becoming persistent without unnecessarily weakening an economy that is already facing significant external pressures.

The likely strategy is therefore a limited tightening followed by an extended period of restrictive monetary policy. Policymakers would then have time to observe whether energy prices decline, whether underlying inflation remains contained and whether the shock feeds into wages and services.

Stronger growth gives the ECB room to act

The euro zone’s economic performance has made the decision easier. The economy grew 0.4 percent in the second quarter, significantly stronger than many economists had expected. Forecasts for full-year growth have also been revised upward, with the latest median estimate putting 2026 growth at 0.8 percent, compared with 0.5 percent in the previous survey.

The growth figures do not indicate that the euro zone is experiencing a powerful expansion. Annual growth remains modest and the economy continues to face high energy costs, geopolitical uncertainty and weak external demand in some major markets. But the stronger-than-expected performance reduces the immediate risk that another 25 basis point increase would push the economy into a severe downturn.

This creates a narrower policy dilemma than the ECB faced during earlier tightening cycles. The central bank is not choosing between inflation and a rapidly collapsing economy. Instead, it is attempting to contain persistent inflation while the economy shows enough resilience to absorb a modest increase in borrowing costs.

The resilience is also important because monetary policy works with a lag. The ECB does not need to respond only when inflation has already become entrenched. By moving while growth remains positive, policymakers can attempt to limit the transmission of higher energy costs into broader prices before the effects become harder to reverse.

The danger is turning an external shock into domestic inflation

The ECB’s biggest concern is therefore not the current oil price itself but what happens after the initial increase. Energy is an input into almost every part of the economy, from transportation and manufacturing to food distribution and services.

If the conflict remains unresolved and energy prices stay elevated, companies could face continuing pressure on operating costs. Some businesses may respond by increasing prices, while workers may seek compensation for declining purchasing power. Those developments could keep services and core inflation elevated even after the initial energy shock begins to fade.

The ECB has already seen signs that some measures of underlying inflation have been affected by the energy shock. Its policy statements have repeatedly emphasised the need to monitor wage-setting, inflation expectations and broader price behaviour rather than focusing only on headline inflation.

This creates a difficult timing problem. If the ECB waits until second-round effects are clearly visible, it may have to tighten much more aggressively later. If it acts too early and the energy shock fades rapidly, it risks imposing unnecessary pressure on growth.

The expected September increase represents an attempt to manage that risk before the evidence becomes unequivocal.

The 2011 comparison carries a warning

If the expected move takes place, the ECB’s tightening cycle would be unusually short, with the central bank raising rates only twice in response to the current energy shock. That invites comparisons with 2011, when the ECB also raised rates in response to an energy-price surge before reversing course as the euro zone economy weakened.

The comparison is important because it demonstrates the danger of treating an externally driven energy shock like ordinary inflation. Higher interest rates cannot increase oil supply. They can only reduce demand and influence broader inflation expectations. If the underlying shock is temporary, aggressive tightening can weaken economic activity without solving the original problem.

The ECB is therefore trying to avoid repeating that mistake. Its current approach is more cautious, with policymakers emphasising data dependence and meeting-by-meeting decisions rather than committing to a predetermined sequence of increases.

The difference from 2011 is also visible in the central bank’s communication. Officials are openly discussing downside risks to growth alongside upside risks to inflation, recognising that a prolonged energy disruption can produce a combination of higher prices and weaker economic activity.

Inflation may remain above target into 2027

The latest forecasts suggest that the inflation problem will not disappear quickly. Economists have pushed their inflation expectations for the second half of 2026 higher, with forecasts around 3 percent or above. Inflation is not expected to return sustainably to the ECB’s 2 percent target until the second half of 2027.

That outlook makes the expected September increase more than a reaction to one month’s inflation figure. It reflects a broader assessment that the energy shock has altered the inflation path for the euro zone and that policymakers need to prevent temporary pressure from becoming persistent.

At the same time, keeping rates at 2.50 percent after September would leave the ECB with room to respond later if inflation remains higher than expected. Conversely, if energy prices fall and underlying inflation continues to moderate, the central bank could avoid further increases and allow restrictive policy to work gradually.

The emerging policy path therefore reflects a compromise between two risks. One is allowing an energy-driven inflation shock to spread through the economy. The other is tightening too much against a supply disruption that monetary policy cannot directly solve.

The September decision is consequently likely to be less about launching a new tightening campaign than about closing the current one with a clear signal that persistent inflation will not be tolerated. The ECB’s challenge after that will be to determine whether 2.50 percent is sufficiently restrictive to contain second-round effects without turning an energy crisis into a broader economic slowdown.

For now, the stronger growth data give policymakers some room to act, while persistent energy inflation gives them a reason to do so. The central question for the period after September will be whether the energy shock fades quickly enough for the ECB to remain on hold, or whether continued disruption forces the central bank to reconsider its assumption that one final increase will be enough.

(Adapted from EuroNext.com)