Europe’s Interest-Rate Problem Gets More Complicated as Energy Shock Deepens

Europe thought it had finally reached the easier part of the inflation cycle. That assumption is now being tested. The European Central Bank raised rates by another 25 basis points last week, taking its deposit rate to 2.5 per cent, but the move has done little to settle the question that matters to businesses and investors: how high do rates ultimately need to go when inflation is being pushed higher by an energy shock rather than an overheating economy?

The ECB is caught between inflation and growth

The problem is unusually awkward because the eurozone is not dealing with a conventional demand-driven inflation surge. The Middle East conflict has pushed energy prices sharply higher, feeding directly into transport, manufacturing and household costs. The ECB now expects headline inflation to average 3 per cent in 2026, 2.5 per cent in 2027 and 2.1 per cent in 2028, while growth is forecast at only 0.9 per cent this year. That is hardly the backdrop in which a central bank wants to keep tightening aggressively.

This is where the economics become more interesting than the headline rate decision. Raising interest rates cannot produce another barrel of oil. Nor can it reopen disrupted supply routes or reduce the cost of imported energy. What higher rates can do is weaken demand, cool investment and make it harder for companies to pass higher costs through to consumers. The ECB is therefore trying to stop a supply shock becoming a broader inflation problem without turning an already fragile recovery into a recession.

EBM has followed this tension closely in its earlier analysis of Europe’s stagflation problem. The uncomfortable feature of the current cycle is that the ECB could conceivably succeed in bringing inflation down while simultaneously making the economy weaker — not because monetary policy caused the original shock, but because it is being used to prevent the shock from becoming permanent.

The encouraging number is hiding underneath headline inflation

There is one reason Frankfurt can afford to remain cautious. The underlying inflation data are nowhere near as alarming as the headline energy number. Inflation excluding food and energy was 2.4 per cent in July, down from 2.5 per cent, while services inflation fell to 3 per cent. Compensation per employee grew 3.3 per cent in the second quarter, down from 3.5 per cent previously, and the ECB says there is currently no material wage response to the energy shock.

That matters enormously. The ECB’s real fear is not expensive petrol or gas by themselves. It is the second-round effect: workers demanding higher wages because living costs have risen, companies lifting prices to protect margins, and consumers beginning to expect permanently higher inflation. If that chain reaction does not materialise, the central bank has considerably more room to wait.

ECB Vice-President Boris Vujčić made precisely that point on Friday, cautioning markets against assuming that higher energy prices automatically mean more rate rises. He said policymakers would assess a broad range of economic indicators rather than simply reacting to the oil price. ECB policymaker Olli Rehn has also said there are currently no clear signs of second-round inflation effects.

But bond markets are already doing some of the ECB’s work

The complication is that financial markets do not need the ECB to announce another hike before tightening conditions themselves. German 10-year Bund yields recently reached their highest level since 2009, before retreating as oil prices eased. Traders have been pricing the possibility that the ECB’s 2.5 per cent deposit rate could rise towards roughly 2.85 per cent by year-end.

That repricing matters because the cost of money for European companies is determined by more than the official ECB rate. Corporate bonds, bank lending, property finance and private-equity transactions all respond to government bond yields and expectations about future rates. EBM has previously examined Europe’s changing rate cycle, and the latest moves suggest that companies may have to operate with a higher cost of capital for considerably longer than they expected at the beginning of the year.

The real danger is not inflation alone

For businesses, the more subtle risk is that Europe ends up with the worst of both worlds: expensive energy and expensive money. Manufacturers face higher input costs just as financing becomes more expensive. Consumers have less disposable income after paying larger energy bills, while companies considering new factories, acquisitions or expansion have to clear a higher return hurdle before committing capital.

That is particularly important because Europe is simultaneously trying to encourage enormous investment in defence, infrastructure, energy networks and artificial intelligence. The ECB itself notes that manufacturing is improving partly because governments are increasing defence and infrastructure spending, while companies are investing in AI.

The irony is obvious. Governments want more investment precisely when monetary policy is making investment more expensive.

For now, Frankfurt appears unwilling to pre-commit to another move. That is probably the only sensible position when the central bank cannot know how long the energy shock will last. If oil retreats, today’s inflation could prove temporary. If energy prices remain elevated for months, the pressure on wages and services could eventually force the ECB’s hand.

The European rate story has therefore become less about whether inflation is high and more about what kind of inflation it is. That distinction will determine whether 2.5 per cent is close to the peak — or merely another step in a tightening cycle that nobody wanted.

And that is the uncomfortable reality for European business: the ECB can control the price of money, but it cannot control the price of oil. Europe is now paying for both.