Why the ECB Faces Its Hardest Decision Since 2022: Raise Rates or Accept Inflation?

The ECB is under pressure to raise rates as Iran war sends inflation back above 3%. Here is the impossible dilemma facing Christine Lagarde and why either choice carries serious risks.

Central bank governors are paid to make decisions that have no good option — only options with different risk profiles and different distributions of winners and losers. What Christine Lagarde and the ECB Governing Council face in April 2026 is one of those decisions, and it is harder than anything they have navigated since the initial inflation surge of 2022.

The structure of the problem is deceptively simple. European inflation, which had been declining steadily toward the ECB's 2 percent target and was widely expected to remain there through 2026, has reversed sharply. Goldman Sachs projects it at 2.7 percent in March, accelerating to 3.2 percent in the second quarter. The energy component, which was negative for much of the past year, has swung violently positive as Iran war oil and gas prices feed through to consumer prices.

In a textbook inflation response, the ECB would raise interest rates: making borrowing more expensive reduces demand, reduces economic activity, and therefore reduces upward pressure on prices. The bank has done this before, successfully, during the 2022-2024 inflation episode.

But this is not 2022. The current inflation is not demand-driven. It is supply-driven — a shock to the energy supply side of the economy that is simultaneously raising prices and reducing economic output. The same high energy costs that generate the inflationary headline number are also compressing household spending, reducing industrial output, and weakening growth. The economy is not running hot. It is being hit by a cold water pipe on one side and a fire hose on the other.

Raising interest rates in response to supply-side inflation is, in economic terms, largely futile for controlling the energy price component — interest rates do not open the Strait of Hormuz. But it does risk tipping an already weakening economy into recession. The ECB's hold decision at its March meeting was defensible. By April, the pressure to act one way or the other will be difficult to resist.