The European Central Bank lifted its deposit rate by a quarter-point to 2.25% this month, the first increase in nearly three years, as President Christine Lagarde acknowledged that the inflation shock from the Middle East conflict is “too large to be ignored without compromising our target.” Yet in testimony before the European Parliament’s economic committee on Monday, she pushed back against fears of persistent second-round effects, saying there were no signs of de-anchored inflation expectations that would warrant a more forceful monetary response at this stage.

The war is weighing on economic activity, particularly in services, where surveys point to a slowdown. Manufacturing, however, has shown resilience, partly reflecting stockpiling in response to supply-chain pressures and increased defence spending, Lagarde noted. ECB staff projections foresee real GDP growth of 0.8% this year, 1.2% in 2027 and 1.5% in 2028, with domestic demand weaker than forecast in March because the conflict has hit confidence and higher energy costs are eroding real incomes. Household balance sheets remain solid, and consumption is expected to remain the main growth driver, supported by business investment in digital technologies and public spending on defence and infrastructure.

Viewed from Frankfurt, the central bank’s stance is that the current shock is less severe than the 2021–22 episode, but Lagarde cautioned against complacency, noting that wage formation may be more sensitive to new shocks after the recent inflation experience. Core inflation, excluding energy and food, accelerated to 2.6% in May from 2.2% in April, according to revised data. Oil prices fell below $80 a barrel on Monday after Washington and Tehran agreed on a roadmap for a final deal, easing some pressure on policymakers. Still, money markets are pricing in at least one further quarter-point rate rise this year, taking the deposit rate to 2.5%. Lagarde stressed the ECB would proceed meeting-by-meeting, data-dependent, to keep its response proportionate as the crisis evolves.

In a separate but related intervention, Lagarde urged G7 leaders to discuss the undervaluation of the Chinese yuan as part of broader efforts to tackle excessive global imbalances that threaten economic stability. She dismissed the idea of a new Plaza Accord to strengthen the yuan, saying “times were different,” but insisted that currency aspects of imbalances merited further talks. Analysts in Moscow, meanwhile, attribute the global tightening trend to the Middle East war and the ensuing fuel-price spike, while noting that Russia’s own tight monetary policy is driven more by domestic labour-market rigidities and fiscal expansion. The next ECB policy meeting will be closely watched for any shift in the balance of risks, as the bank navigates between upside inflation pressures and downside growth threats.