ECB Raises Rates, Says Pausing Is an Option

FRANKFURT—The European Central Bank raised its key interest rate by a quarter percentage point and signaled it might pause rate hikes at its next meeting, as it tries to balance its campaign to bring down high inflation against recession fears.

The rate increase, the ECB’s ninth in a row, was widely expected and will take its deposit rate to a 22-year high from below zero a year ago.

The ECB said it would increase its deposit rate to 3.75%. “While some measures show signs of easing, underlying inflation remains high overall,” it said in its statement.

“We have an open mind as to what decisions will be in September and subsequent meetings…We might hike and we might hold. And what is decided in September is not definitive, it may vary from one meeting to another,” ECB President Christine Lagarde said. Future rate decisions would be based on incoming economic data, she said.

The euro fell 0.7% against the dollar, erasing a gain of about 0.5% from earlier in the day. The euro’s slide was exacerbated by data showing the U.S. economy grew faster than expected last quarter, which lifted the U.S. dollar against foreign currencies. European government bonds rose while European stocks held on to gains.

Major central banks are signaling that interest rates are approaching a peak after more than a year of aggressive rate hikes. But they are wary of declaring victory over inflation, which has proven a more stubborn foe than expected over the past two years. Inflation is declining on both sides of the Atlantic but it remains too high, especially in Europe.

Central banks in Australia, Canada and the U.S. recently paused their rate increases for several weeks or months, only to start raising rates again. The Federal Reserve on Wednesday raised its benchmark rate to a range between 5.25% and 5.5% following a brief pause in increases last month, and Fed Chair Jerome Powell said it was too soon to tell whether the hike would conclude the Fed’s series of increases. The Bank of England is expected to increase interest rates by at least a quarter point next week from 5% at present.

The next rate decision “could be a hike, could be a pause, and if a pause it will not necessarily be for an extended period of time because we continue to decide on a meeting by meeting basis based on data,” Lagarde said on Thursday.

While the U.S. economy is growing robustly, the eurozone has been flirting with recession since the end of last year, when it began stalling. Business surveys point to more pain ahead, especially in Germany, the currency area’s largest economy. Bank lending is deteriorating dramatically, with demand for business loans declining to a record low.

Europe’s economic headwinds should help tame inflation, which declined to 5.5% in the eurozone in June, the lowest level in nearly 18 months, though still far above the ECB’s target of 2%. The ECB’s rate increases should also bear down on business and household spending with a lag.

On the other hand, Europe’s jobs market has proven robust, and wages are rising briskly. That means core inflation in the eurozone, which excludes food and energy and is considered a better measure of where inflation is headed, has hovered around 5% for nearly a year.

All that means it isn’t clear if the ECB’s moves are helping push inflation down toward 2% with a lag, or whether price pressures are likely to stay high. Investors expect the ECB to raise rates toward 4% later this year before starting to cut rates later next year, according to data from Refinitiv. ECB officials have signaled that borrowing costs are likely to stay high for some time, and that fresh data over the coming months will be critical in determining how much more rates need to rise.

“The ECB will probably raise interest rates less than the Federal Reserve, but will have to keep them at this level for a longer period of time,” said Marco Wagner, an economist with Commerzbank.

Earlier this week, International Monetary Fund officials urged the ECB to consider raising rates above 3.75% to prevent high inflation from becoming entrenched. As eurozone workers try to recoup losses in purchasing power by pushing for higher wages, businesses are reacting by raising prices to offset higher labor costs and protect or widen their profit margins.

“We do not see [eurozone] inflation coming back to target before mid-2025,” wrote Alfred Kammer, the director of the IMF’s European department, and his colleague Luis Brandao-Marques, in a blog post.

Sticky inflation would ultimately force the ECB to raise rates higher and for longer to return it to target, causing a sharper economic downturn later, the officials warned.

—Chelsey Dulaney contributed to this article.

Write to Tom Fairless at [email protected]