The European Central Bank has raised interest rates to 2.5% and warned that the risk of higher inflation over the next year has risen following renewed fighting in the Middle East.
It came as government borrowing costs soared on the back of a jump in oil and gas prices following the latest US and Iran attacks on ships in the strait of Hormuz.
The interest rate, or yield, on UK government debt rose to a 19-year high on Thursday, while those on US and European bonds also climbed in line with oil, which touched $105 (£78) a barrel.
Investors had expected the ECB to raise the cost of borrowing across the euro bloc, but were spooked by the hawkish tone of the central bank’s report, which warned of inflationary pressures building in many sectors of the economy.
Increasing its main rate from 2.25% to the highest level since March last year, the central bank lifted its forecast for eurozone economic growth in 2026 to 0.9%, up from 0.8% in June. It now expects inflation to average 3% this year.
The biggest driving force of rising prices is the cost of energy, which again jumped on Thursday on the back of this week’s increase in US and Iranian attacks on ships transiting the Gulf.
Brent crude passed $105 a barrel, before slipping back to about $104.5, a 3.3% rise on the day. British gas prices rose to above 203p per therm, the highest since December 2022.
Continental European gas prices also rose. The Dutch wholesale gas price – the EU standard – passed €80 per megawatt hour (MWh) for the first time since January 2023. The front-month contract is trading 3.4% higher at €82.56/MWh.
This in turn fuelled climbing government borrowing costs in leading economies. The interest rate on benchmark 10-year UK government bonds, also known as gilts, hit 5.36%, the highest since August 2007.
The rate, or yield, on Germany’s 30-year government bond rose 2.5 basis points to 5.08%, the highest since December 2003. The 10-year yield hit 3.45%, the highest since April 2011. France’s 10-year government bond yield was the highest since October 2008 at 4.344%, up 1 basis point.
Central banks are concerned that high fuel and energy prices will feed into higher transport costs and more expensive heating for commercial and residential properties, which will lead to a broad-based rise in inflation.
The ECB president, Christine Lagarde, said: “We believe inflation will be longer lasting than we had anticipated,” adding that food inflation, which had remained low at 1.2%, was likely to increase in response to higher oil and gas prices.
She explicitly acknowledged that gas prices could rise due to further supply disruptions or an unusually cold winter in combination with low storage levels across much of the region.
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Investors are concerned that UK and EU governments have underplayed the risk of running out of gas and the negative effect a subsequent dash for supplies will have on inflation. Recent data shows EU gas stores are only 67% full, well below the five-year average of 84%.
UK and continental European gas buyers have delayed filling gas stores in the expectation that the Middle East conflict will be resolved and prices will be lower before winter in the northern hemisphere. As the war drags on, there is the prospect of gas prices rising due to a scramble of buyers looking to replenish stocks in the remaining months before cold weather arrives.
Bond markets were also put on alert by the US treasury secretary, Scott Bessent, who said the US would buy back $6bn worth of government debt – known as US treasuries – in an effort to alleviate a sell-off in the US bond market that has put pressure on interest rates.
But the size of the package was considered inadequate by bond buyers and the yield on 10-year treasuries rose to a three-year high.
“Headline inflation is expected to return to around target towards the end of 2027, supported by the effects of higher interest rates,” Lagarde said.
Asked about the ECB’s next move, she added: “We have not debated at all any kind of future path. Markets do what they have to do and we do what we have to do – which is to provide price stability.”