Euro zone inflation is back above 3%. Higher interest rates are likely to follow

Energy price pressures drove inflation in the euro zone back above 3% in August, with hard-hit businesses now likely facing a second blow from higher interest rates.

Headline inflation in the euro area — a net importer of energy — rose to 3.3% from 2.9% in July, the highest level since September 2024, according to a flash estimate published by statistics office Eurostat on Tuesday. Energy inflation accelerated to 14.3% from 10.3%.

But core inflation, which excludes the volatile components of energy, food, alcohol and tobacco, dipped to 2.4% from 2.5%.

The Iran war and blockage of the Strait of Hormuz have ramped up the cost of crude oil and refined products, while Europe has been especially impacted by disruption in the natural gas market.

Traders locked in their expectations for the European Central Bank to hike interest rates at its Sept. 10 meeting, with market pricing on Tuesday morning putting a 98.9% probability on a 25 basis point increase to 2.5%, according to LSEG data.

The ECB raised its key rate to 2.25% in June, the first hike since 2023, in response to global inflationary pressures resulting from the Iran conflict.

The central bank will be wary that short-term inflation pressures become structural, feeding into wages and services inflation, Joe Nellis, head of economic research at MHA, said in emailed comments.

"The ECB faces a dilemma: a trade-off between higher interest rates and economic cost. Higher borrowing costs will continue to squeeze heavily indebted households, weaken housing markets and make investment more expensive for businesses."

"For SMEs in particular, another increase in financing costs could mean investment plans being indefinitely postponed or abandoned altogether."