Renewed Hormuz hostilities drive ECB rates rethink amid ‘extremely volatile’ outlook

Several consecutive days of strikes exchanged between the U.S. and Iran have once again thrown oil prices into the spotlight — and cast uncertainty on the European Central Bank’s interest rate decision next week.

Investors on Wednesday were repricing for the ECB’s July 22 monetary policy meeting as soaring oil prices have put expectations for a hold in doubt.

“The renewed outbreak of military conflict in the Middle East and the fresh rise in oil prices underscore that the situation remains extremely volatile and the uncertainty is similarly high,” Bundesbank President and ECB rate setter Joachim Nagel told Reuters on Wednesday.

“It remains advisable to react with caution, but to act decisively if necessary,” he said. “Monetary policy will maintain its vigilant stance.”

The ECB slashed interest rates four times in the first half of 2025, taking its key deposit rate from 3% at the start of the year to 2% by mid-June. But last month it was forced to change course, hiking by 25 basis points to its current rate of 2.25%.  

Headline inflation hovered close to the ECB’s 2% target before the outbreak of the Iran war and then accelerated to a peak of 3.2% in May. Initial estimates show eurozone inflation eased to 2.8% last month despite a 8.7% year-on-year increase in energy costs for the month, as core inflation was restricted to 2.4% — suggesting limited “second-round” inflation effects in the rest of the economy.

But energy prices have once again shot higher this week as several consecutive days of hostilities between the U.S. and Iran over the control of the strategically vital Strait of Hormuz reignited fears over oil supply. September Futures for international benchmark Brent crude traded higher again early on Wednesday, above $85 per barrel, having traded closer to pre-war levels around $70 just last week.

The price of oil is critical for the eurozone economy, which imported 57% of its energy needs in 2024, according to the most recent available data from Eurostat.  

But policymakers will also be cautious that an overly restrictive monetary policy stance could tip the eurozone economy into recession after contracting by 0.2% year-on-year in the first quarter of 2026.

Policymakers will also be conscious that initial estimates for second-quarter GDP growth and July inflation will not be available until July 30 and July 31, respectively – meaning next week’s rates decision will be made without access to the most recent data.

ING rates strategists Michiel Tukker and Benjamin Schroeder wrote in a Wednesday note that eurozone inflation data “will be pivotal in challenging the hawkish market positioning,” but “even then, those numbers will not be enough to comfort markets about second-round risks.”

“All this uncertainty means markets’ European Central Bank pricing can continue to diverge from the Fed’s,” they said. “The momentum in US inflation should be downwards, whereas for Europe the peak might not be in sight yet, especially if energy prices continue to drift higher again.”

The fall in oil prices last month had led investors to effectively rule out an ECB rate hike next week, and current market pricing still points to a roughly 20% chance of a hike. But investors still expect two more 25 basis point rate hikes by next spring, taking the ECB’s key deposit rate to 2.75%.

“At the moment we are paying particular attention to the indirect price effects of the war in the Middle East and possible second-round effects,” Austrian central bank chief Martin Kocher told German newspaper Börsen-Zeitung on Wednesday. “We currently see no second-round effects, but must also align our monetary policy with inflation expectations,” he said.