Interest rates around the world are rising as investors price in higher monetary policy rates from central banks attempting to tamp down inflation. The situation is global, but some economies are experiencing the crisis more acutely, such as the Eurozone and the ECB. Europe imports the majority of its energy, and after years of disruptions from the war in Ukraine, is particularly vulnerable to price increases. As a result, the Euro is at risk going into the upcoming central bank meeting cycle.
To illustrate the problem, on Thursday, ECB’s Olli Rehn of Finland argued for raising rates, saying it might be necessary to “maintain credibility”. This is central bank speak for suggesting that inflation expectations could push inflation higher on their own. Therefore, the central bank needs to get ahead of the actual increase in inflation to prevent prices from rising even faster. He illustrates the kind of thinking that would push the ECB to raise rates sooner rather than later.
The Problem With the ECB Raising Rates
Rate hikes are the classic monetary policy measure to curb rising consumer prices by raising the cost of credit and slowing the economy. The problem is that the current circumstances are not driven by an overheated economy but by a specific issue well outside the bounds of monetary policy.
Oil prices are higher because supply is constricted. Raising rates will not open the Strait of Hormuz. Therefore, the price of oil will stay the same, and so will its inflationary impact. The ECB cannot drive down petrol prices at the pump, nor make aviation fuel available at airports. What it can do is lower prices in other areas which are sensitive to interest rates and offset the increase in energy prices.
Not All Inflation Is the Same
On balance, a rate hike will presumably lower the inflation reading, but the economic impact will be different. Higher fuel prices weigh on the economy because it makes doing business more expensive, since pretty much everything needs energy to run. A rate hike does nothing to reduce this negative impact on the economy. In fact, it’s another blow to the economy in a different sector.
In other words, the ECB can keep the overall rate of consumer price inflation under control, even as energy prices rise. But the cost is a double punch to the economy. The Eurozone economy is already fairly weak, growing just 0.1% in the first quarter. It was already impacted by rising energy costs in just one out of three months. Q2 GDP growth will presumably be worse as all three months are affected by higher energy costs. Add on top of that higher interest rates from an ECB that feels compelled to raise rates to preserve its credibility, and the economy could drag down even more.
The Euro on Shaky Ground
The EURUSD is still up over 10% over the last year, despite declining since the start of the war. It was up over 17% in 2025 but has been losing some ground. The key issue here is that the bulk of its gains last year were due to expectations that its more stable political regime and increased government spending would drive economic growth faster than the US. Investors sold dollars to buy Euros.
But if the Eurozone economy is about to slump because of higher energy costs compounded by higher interest rates, those flows could quickly reverse. Particularly if the US economy rebounds as a net energy exporter rather than a net energy importer, as in the Eurozone. In that case, the Euro could weaken even as rates rise. Particularly if there is no quick resolution to the conflict in the Middle East.
