The escalating conflict in the Middle East ignites inflation in Europe! The eurozone CPI rises to 2.9%, and the European Central Bank is poised to raise interest rates in September.

Amid the escalating geopolitical conflicts in the Middle East following the breakdown of the ceasefire agreement between the United States and Iran, international oil prices have soared significantly. In the Eurozone, inflation in July picked up, further reinforcing the hawkish expectations for the European Central Bank (ECB) to raise interest rates again. The European Union's statistical office reported on Friday that consumer prices rose by 2.9% year-on-year, up from 2.8% in June. This figure aligns with the consensus median estimated in an economist survey compiled by various agencies, and inflation rates reported by France and Spain were both significantly higher than expected. Within the Eurozone, which consists of 21 countries, energy prices unexpectedly surged by 10% in July, and both the inflation indicators for the service sector and the core inflation indicator, which excludes volatile items like fuel and food, also accelerated. This report was released just a week after ECB policymakers decided to pause raising the benchmark borrowing costs. This pause was intended to allow policymakers more time to collect information on how the renewed escalation of geopolitical conflicts in the Middle East would impact inflation and economic growth in the Eurozone. Economists and investors almost unanimously expect that the ECB will raise rates in September, following the 25 basis point increase in June. As shown in the graph above, Eurozone inflation accelerated in July. Source: Eurostat. At last week's meeting, ECB policymakers kept borrowing costs unchanged, having previously raised rates by 25 basis points in June. Recently, media reports indicated that insiders have stated that unless there is a significant improvement in the inflation outlook, policymakers are prepared to raise rates again in September. Members of the ECBs Governing Council, including the Governor of the Slovak National Bank, Peter Kazimir, have warned that the ECB cannot simply wait for the actual effects to manifest, as it might be too late to take action by then. The primary reason for the substantial escalation of the U.S.-Iran conflict is that the previous brief ceasefire did not resolve the core issue of control and freedom of navigation in the Strait of Hormuz. A preliminary agreement on June 18 briefly allowed shipping to resume, but the U.S. subsequently demanded that Iran halt attacks on vessels, fully open the waterways, and not impose tolls; Iran insisted on its control over the security and order of navigation in the Strait. In July, the United States intensified its airstrikes on Iranian southern coastal and missile and drone facilities to forcibly restore navigation, while Iran expanded its retaliatory attacks to the U.S. military bases or ports in countries like Qatar, the UAE, Kuwait, and Jordan. The immediate trigger for the latest escalation was a missile attack by Iran on U.S. forces stationed in Jordan, leading to a U.S. operation that targeted dozens of Iranian Revolutionary Guard command and drone facilities for about two hours; concurrently, the U.S. and Saudi Arabia struck pro-Iranian armed groups in Iraq, while Houthi forces attacked Saudi energy facilities, evolving the conflict from a bilateral U.S.-Iran confrontation into a multi-front energy war covering the Gulf, Iraq, the Red Sea, and the eastern Mediterranean. Following the mid-July increase in U.S. blows against Iran, shipping volumes through the Strait of Hormuz markedly decreased; afterward, Tehran retaliated against U.S. ally nations, including Kuwait, by launching attacks against their military bases or ports. This week, after a brief ceasefire, hostilities resumed, but U.S. Energy Secretary Chris Wright stated that oil is still being transported despite U.S. military support. In a media interview, he stated: We are utilizing American military forces to escort oil and natural gas out of the Strait of Hormuz. He added that approximately 6.5 million barrels of oil were carried out of the Persian Gulf through this vital strait on average per day over the past week. We are restoring oil and refined oil supplies for global markets in this region. The resumption of conflict in the Middle East reignites the inflation curve in Europe. Kamil Kovar, head of Eurozone forecasts at Moodys Analytics, stated: The data released today, along with developments in the Middle East during July, largely clarifies that the ECB is on track to restart rate hikes in September. German government bonds retraced earlier gains to turn down, pushing the yield on 10-year bonds up by 1 basis point to 3.16%. The money market still expects a 90% probability of a 25 basis point rate increase in September, but has slightly raised bets on further tightening, with current pricing showing an expected total increase of 42 basis points for the year. Before the September meeting, officials will also receive a set of August inflation data, along with the latest economic forecasts compiled by ECB staff. Although ECB President Christine Lagarde rejected advance commitments to take action last week, some of her colleagues have almost clearly indicated the future policy direction. Austrian National Bank President Martin Kocher stated in a media interview on Friday that uncertainty and volatility remain very high. Previously, Gediminas Simkus, the Governor of the Lithuanian National Bank, stated that the likelihood of a rate hike is far higher than maintaining rates unchanged. His Slovak counterpart, Kazimir, went further, arguing that the ECB must raise rates at least once more, even if inflation conditions improve. As shown in the graph above, all Eurozone countries except Estonia have inflation rates exceeding the ECBs inflation anchor benchmark of 2%the year-on-year change in consumer prices. Currently, the signals released from the geopolitical situation in the Middle East are mixed. Although the U.S. and Iran have resumed mutual airstrikes, shipping volumes through the Strait of Hormuz have seen some recovery. While oil prices have fallen back below $100 per barrel, they remain at historically high levels. At the same time, a survey by the ECB indicated that wage growth is expected to continue accelerating until early 2027. ECB officials are closely monitoring wage changes to determine whether rising energy costs will cause inflation to stay elevated in the long term. Nonetheless, the Eurozone economy has so far shown an unusually strong capacity to withstand this crisis. Economic output in the second quarter grew at the fastest rate in over a year, reaching twice the expected increase, with all four major economies in the Eurozone recording growth. The door for a rate hike in September is wide open. Restarting rate hikes on September 10 has now become the ECB's baseline scenario, but it is not yet set in stone. Eurozone CPI year-on-year rose from 2.8% to 2.9% in July, core inflation rose to 2.5%, and service sector inflation rose to 3.3%, while energy prices increased by about 10% year-on-year; this indicates that the U.S.-Iran conflict and oil price shocks are no longer affecting only overall inflation but have begun to spread to more persistent core inflation. Meanwhile, Eurozone GDP grew by 0.4% quarter-on-quarter in the second quarter, surpassing expectations and reducing concerns for the ECB about tightening policy due to recession risks. The current market pricing probability for a 25 basis point rate increase in September is about 90%. The policy stance of the ECB Governing Council, composed of the central bank governors of Eurozone countries, is also clearly hawkish: the ECB paused rate hikes in July primarily to observe the duration of the energy shock, rather than to declare the end of the tightening cycle; the official statement emphasized that energy prices remain significantly above the levels seen before the Middle East conflict, and the full impact of inflation has yet to be seen. Although Lagarde insists on the decision-making at each meeting and refuses to commit in advance, she has clearly left room for a rate hike in September; Kazimir even believes that at least one more rate hike may be necessary, even if the situation improves slightly. Unless there is a notable decline in August inflation, a rapid drop in oil prices, and a simultaneous cooling of wages and service inflation, the likelihood of a 25 basis point rate hike by the ECB in September is very high. The real uncertainty does not lie in whether there will be another increase, but in whether to continue tightening after September: If the energy price shock is temporary and does not create a wage-price spiral, the ECB might consider a "one-time insurance rate hike followed by observation"; if oil prices remain high and push core inflation higher, the cumulative tightening for the year may exceed one increase.