ECB holds rates at 2.25% as Middle East tensions weigh on euro

The European Central Bank held its deposit rate at 2.25% on Thursday, declining to hike despite elevated energy prices from the Middle East conflict, a decision that pushed the euro to session lows against the dollar.

"Underlying inflation remains contained, but the longer energy prices stay high, the more likely we are to see second-round impacts," ECB President Christine Lagarde said at the press conference. "The full inflationary impact of the energy shock has yet to play out."

The euro fell 0.4% to $1.0825 following the decision, extending its weekly decline as the dollar benefited from safe-haven flows amid renewed hostilities in the Strait of Hormuz. Markets now price a 23-basis-point hike at the ECB's September meeting, according to swaps data, suggesting investors expect the central bank will eventually need to act if oil prices remain elevated.

The decision leaves the ECB trailing the Federal Reserve and Bank of England, both of which also held rates this month but face their own policy meetings next week. With the US dollar index climbing to a three-week high and Brent crude above $82 a barrel, the eurozone faces the dual risk of imported inflation and reduced export competitiveness if the single currency continues to weaken.

The Governing Council kept all three key rates unchanged — the deposit facility at 2.25%, the main refinancing operations at 2.40% and the marginal lending facility at 2.65% — in a decision widely anticipated by markets. The ECB said it was closely monitoring the intensity and duration of the energy shock as well as its indirect and second-round effects, and reiterated it was not pre-committing to a particular rate path.

The hold comes as the eurozone confronts a complex inflation picture. Headline CPI has moderated from the peaks triggered by the initial energy shock, and Lagarde noted that forward-looking indicators suggest only modest growth in the medium term. Yet the ECB's June staff projections, which serve as the baseline for policy, assume energy prices remain close to current elevated levels — well above where they stood before the conflict erupted.

The last time the ECB faced a comparable energy-driven inflation shock was in 2022 following Russia's invasion of Ukraine, when the central bank raised rates by a cumulative 450 basis points over 14 months. The current situation differs in that the eurozone economy is weaker, giving the Governing Council less room to tighten without exacerbating the growth slowdown.

Across the Atlantic, the Federal Reserve will announce its rate decision on July 29, with Chair Kevin Warsh expected to hold the federal funds rate at 3.5% to 3.75% for a second consecutive meeting. The Bank of England follows on July 30, with Governor Andrew Bailey having warned that higher energy prices over the past four months have created inflationary pressure in the pipeline that could keep UK rates at 3.75% longer than previously expected.

Oil prices remain the key variable. Brent crude rose above $82 a barrel this week after the US and Iran resumed attacks in the Strait of Hormuz, reversing some of the declines seen during earlier ceasefire periods. UK household energy bills rose after the latest increase in the price cap took effect on July 1, a dynamic that could push eurozone inflation higher in coming months as the energy shock transmits through the broader economy.

For currency markets, the policy divergence is becoming more pronounced. The dollar index climbed to a three-week high as the combination of Fed patience and geopolitical risk drove safe-haven demand. The euro's decline against the dollar, if sustained, would boost eurozone export competitiveness but raise the cost of dollar-denominated imports, including energy — a trade-off that complicates the ECB's inflation outlook.

This article is for informational purposes only and does not constitute investment advice.