Euro zone inflation accelerated to 3.3% in August from 2.9% in July, driven almost entirely by higher energy costs as crude oil and natural gas prices both rose, and refiners bumped up their margins, according to Eurostat data. The surge has cemented an already solid case for another European Central Bank interest rate hike this month as the Iran war keeps putting upward pressure on prices. Core inflation, which excludes volatile food and fuel prices, eased to 2.4% from 2.5% as growth in services prices, the single biggest component of the consumer price basket, slowed to 3.0% from 3.3%. Tuesday's figures are broadly consistent with the ECB's own expectations and suggest that a widely telegraphed hike in the deposit rate to 2.50% on September 10 will be a relatively easy decision, almost a non-event for markets.
Financial investors have already priced in the September rate hike, suggesting their focus will be on the rate path further down the line, with views diverging on just how deep the euro zone's inflation problems run. Policymakers appear to have no appetite for now to signal any further rate hikes and economists also see a high chance the ECB will stop in September, holding rates at what many consider the top end of the 'neutral' range. This is partly because the labour market is relatively soft and price pressures have not set off any visible rise in wage growth, reinforcing views that only gentle policy tightening may be enough. Economic growth at just around 1% is also fairly weak and was at risk of slowing further if the conflict continued.
According to ING economist James Smith's analysis, Europe's response to the Iran War has been significantly more contained than the 2022 energy crisis following Russia's invasion of Ukraine. By July 2022, energy was contributing approximately four percentage points to eurozone inflation, while today the contribution is less than one quarter of that amount. The distinction matters because markets have moved well beyond pricing resilience, now pricing at least two additional rate hikes from both the European Central Bank and the Bank of England. Smith argues that Europe may be confusing an economy relieved by contained inflation with one strong enough to require substantially tighter monetary policy, noting that Europe entered the Ukraine crisis deeply dependent on Russian pipeline gas without a ready replacement, while today it possesses a more diversified energy network and greater experience managing shortages.
Smith's research reveals that energy-sensitive inflation has barely moved despite the disruption. Using an ECB-developed index tracking goods and services indirectly sensitive to energy prices, which represents roughly one third of eurozone inflation, the results show surprisingly calm conditions. The basket includes items such as airfares, courier services, plants and cafés, with prices not being energy bills but including energy as part of production and operating costs. Even with the latest increase in European natural gas prices, Smith does not expect the comparison to change dramatically, as the present energy shock remains meaningful but has not approached the force of the one that followed the Ukraine invasion. The indirect inflation has barely moved, suggesting the full historical pass-through effect may not materialize as expected, though Smith acknowledges the argument that indirect inflation tends to follow energy prices with a delay of approximately six months.
Food inflation is declining across Western and Central Europe, with food prices in Britain lower than three months ago. Across the three largest Eastern European economies, annual food inflation has turned negative. Most economic models suggest the maximum food price effect from the Iran War will not appear until next spring, but current data shows no visible pressure. This absence of food inflation is particularly significant because it represents one of the clearest transmission points between energy costs and household inflation, reducing the risk that households treat the energy shock as a permanent price level change. Smith notes that food production, fertiliser, refrigeration, processing and transport are all exposed to energy costs, making food prices particularly important for inflation expectations, with households knowing what bread, milk and vegetables cost more than current bond yields.
Smith's analysis shows wage-sensitive eurozone inflation has declined throughout 2026, with the ECB's measure of negotiated wages showing no meaningful acceleration. While advertised salary growth has increased according to hiring data from Indeed, this does not align with the ECB's forward-looking measure. The proportion of eurozone service businesses expecting to raise selling prices has shown no meaningful acceleration, with companies not behaving as though a lasting wage price cycle is imminent. This final link in the inflation chain remains intact, with businesses not preparing new rounds of price increases, though Smith notes that workers require both bargaining power and confidence before demanding compensation for higher living costs.
Markets are pricing expected policy rates approximately one percentage point above where they were before the war, with the hawkish case depending on delayed pass-through effects that have yet to appear in data. Smith does not rule out an ECB hike in September, citing rising natural gas prices and delayed inflation pass-through as defensible reasons for Frankfurt to move once more. However, additional hikes would push policy further into restrictive territory without compelling evidence that the energy shock is spreading through food, wages, services or corporate pricing. Financial markets see two more rate hikes in the next year on the premise that higher energy prices will eventually start seeping into broader price setting, especially since the war in Iran is showing no signs of winding down, keeping inflation high. Still, even if the ECB is forced into further hikes, there appears to be little urgency in follow-up moves, so policymakers may skip the October meeting and focus on the next round of economic projections in December.
