Can the ECB rate hike stop an inflation shock driven by energy costs?

The European Central Bank (ECB) raised its key interest rates by 0.25% on Thursday, bringing the deposit rate to 2.5%. This move is in response to the ongoing energy price shock that has driven inflation higher in the Eurozone. Brent crude oil prices surpassed $100 a barrel in response to the conflict between the United States and Iran, while the Dutch TTF benchmark for gas surged by 190% since the beginning of the year.

Eurozone inflation accelerated to 3.3% in August, up from 2.9% in July, with energy prices rising 14.3% year-on-year.

ECB President Christine Lagarde described the decision as a "no-brainer," stating that the conflict in the Middle East continues to generate inflation pressures and that inflation is expected to remain well above target for an extended period. While higher rates do not directly impact the supply of oil or gas, the ECB believes that cooling demand at home will prevent an imported price shock from becoming a domestic one.

The ECB's main objective is to prevent structural inflation from taking hold, as the current energy shock has already started to influence contracts, transport costs, insurance, and household expectations. Core inflation, which excludes energy, food, alcohol, and tobacco, slightly decreased in August to 2.4% from 2.5%. However, services inflation, the measure the ECB closely watches for signs of domestic overheating, fell to 3.0% from 3.3%. Wages have not shown a significant response to the energy shock so far.

The ECB is not reacting to short-term, supply-driven inflation shocks but is instead preparing for potentially more structural inflation. The real target is to manage expectations, as higher energy prices could intensify further and impact other prices and wages. If workers and employers anticipate continued price rises, the oil shock could evolve into a more prolonged inflation regime.

While inflation is currently projected to remain above the ECB's 2% target through 2027, core inflation and labor costs are not expected to return to 2% by the end of the forecast horizon. Underlying inflation pressures could persist into 2027, necessitating further interest rate hikes. The ECB has upgraded its growth outlook for this year and next, citing positive impacts from technology-related business activity and German fiscal support.

However, the question remains whether the ECB will continue raising rates and for how long, as contained inflation pressures may favor a more reactive or data-dependent approach to policy setting.