Eurozone inflation has picked up speed once more amid the ongoing energy price shock, making it nearly certain that the European Central Bank will raise interest rates in September. Interestingly, underlying inflation slipped against expectations, which adds a layer of uncertainty about the direction of policy after this month's move.

Data released by Eurostat on Tuesday showed that the consumer price index in the euro area rose by 3.3% year-on-year in August, up from 2.9% in July and reaching the highest reading since September 2023, in line with the consensus forecast from a Bloomberg survey. Financial markets are now almost fully pricing in a 25-basis-point hike by the ECB on September 10, which would lift the deposit rate to 2.50%.

The resurgence in inflation is being driven mainly by energy costs. Persistent conflict in the Middle East has kept upward pressure on crude oil and natural gas prices, and those increases are gradually filtering through into the broader consumer sector. ECB Executive Board member Isabel Schnabel stated last week that borrowing costs need to move higher to make sure inflation returns to target.

Adding to that view, Austrian central bank chief Martin Kocher said on Tuesday that "upside risks to inflation have once again increased recently." If the ECB's latest projections validate this assessment, then "a further rate increase will be necessary in the near term."

Energy Costs Lead Inflation Rebound, Core Prices Unexpectedly Cool

The latest acceleration in inflation is almost entirely the result of higher energy costs. As crude and gas prices have climbed, refining margins have also widened, pushing the energy component up noticeably. In Italy, the inflation rate moved from 2.9% to 3.2% in August, while Spain earlier reported a surge to 4.5%. Inflation has also quickened in the eurozone's two biggest economies, Germany and France. In contrast, core inflation, which strips out food and energy, eased unexpectedly from 2.5% to 2.4%, and services inflation declined from 3.3% to 3.0%.

David Powell, senior eurozone economist at Bloomberg, pointed out that the sharp climb in headline inflation contrasts sharply with the slowdown in core price gains, which supports the view that the ECB will not tighten policy as aggressively as financial markets currently anticipate. With the labor market cooling, the pass-through from commodity prices to goods and services prices could stay limited. However, if the energy shock persists for a longer stretch, another hike in December could re-enter the discussion.

September Hike Looks All but Decided, Divergence Remains on What Comes Next

Tuesday's data largely matched the ECB's earlier expectations, so a move to raise the deposit rate to 2.50% on September 10 should be a relatively smooth decision. Attention has shifted from whether the bank would act this month to what happens beyond that, with questions over whether 2.5% marks the peak of this cycle.

ECB Chief Economist Philip Lane has previously described a rate of 2.5% as sitting near the upper edge of the so-called "neutral range." Some officials argue that if the energy shock becomes more persistent, policy rates might need to rise above that threshold. Meanwhile, Executive Board member Piero Cipollone has advocated caution, pointing to the fact that second-round inflation effects from the conflict have yet to materialize fully.

For now, most economists expect the ECB to pause after a September hike, leaving interest rates around the 2.5% mark. A weaker labor market, the lack of any marked acceleration in wage growth, and a sluggish economic expansion of roughly 1% all limit the scope for further monetary tightening.