French inflation exceeded expectations in August, while Spanish inflation rose to 4.5%, a three-year high: the market has fully priced in a September rate hike by the ECB.

Rising energy prices, fueled by the Middle East conflict, pushed up August inflation in both of the eurozone's two largest economies, leading investors to fully price in a potential 25-basis-point rate hike by the European Central Bank at its September meeting.

French inflation accelerated to 2.7% in August, the highest since May and exceeding market expectations; Spanish inflation rose to 4.5% year-on-year, the fastest pace since 2023, slightly below the median forecast in a Bloomberg survey, but still more than double the European Central Bank's 2% target. Rising energy prices were a common driver of the price increases in both countries.

Following the data release, investors have fully priced in the ECB's 25 basis point rate hike in September—a follow-up to the first rate hike in nearly three years in June, which will raise the deposit facility rate from 2.25% to 2.5%. The market also expects another rate hike before the spring of 2027.

More noteworthy is that the July meeting minutes showed that officials had begun discussing whether “moderately restrictive” policies were needed to ensure inflation returned to target, which could mean that interest rates would eventually need to break through 2.5%—the upper end of what chief economist Philip Lane calls the neutral range.

Energy shocks cause inflation to rise again in France and Spain.

Spain's CPI rose 4.5% year-on-year in August, the fastest pace since 2023, and its economic expansion remains among the fastest among major Eurozone economies; France's inflation accelerated to 2.7%, the highest since May, and as the Eurozone's second-largest economy, France's economic growth forecast for the first half of 2026 was significantly revised downward.

Energy is the core driver of inflation in both countries, stemming from the ongoing military conflict in the Middle East.

To cushion the impact of the war with Iran, the Spanish government approved a €5 billion ($5.8 billion) aid package in March, including energy tax cuts. While the measures are still in effect, their scale is less than when they were first introduced. Overall inflation data for the 21 Eurozone countries will be released next week, and analysts expect it to exceed 3%.

Monthly data released by the European Commission on Friday showed that consumer price expectations for the next 12 months rose significantly in August, while business price expectations were above the long-term average across all sectors.

The market has fully priced in a September rate hike, and the debate has shifted to a "restrictive" range.

The market has fully priced in a 25 basis point rate hike in September, which will raise the deposit facility rate to 2.5%.

Minutes from the July meeting released Thursday showed that officials discussed whether a “moderately restrictive” monetary policy was needed to ensure prices return to their target, meaning interest rates could potentially rise above 2.5%—a level Philip Lane had previously described as potentially the upper end of the neutral range.

Paul Hollingsworth, head of developed market economy research at BNP Paribas, said a September rate hike is "almost a done deal," but "the path after September is generally quite uncertain," with the debate likely to shift to whether restrictive policies are needed, or the outcome to be decided at the December meeting.

Officials have issued a series of statements warning of the potential for inflation to take root.

European Central Bank Executive Board member Isabel Schnabel told Bloomberg this week that officials must further increase borrowing costs to curb inflationary pressures stemming from the war in Iran and the economy's continued solid growth despite numerous headwinds.

Management Committee member Martins Kazaks told Latvian TV3 on Friday: "Inflation must not be allowed to take root. One way to reduce the risk of rooted inflation is to raise interest rates, and we have already done that once."

Ana Andrade of Bloomberg Economics points out that Spain's overall inflation surged in August, mainly driven by rising fuel prices. Tax cuts are still in effect but far less stringent than at the beginning of the year. Core inflation has only slightly declined, and underlying price pressures remain sticky. Due to strong wage growth and the economy operating beyond capacity, harmonized core inflation is expected to remain above 3% for the remainder of the year.

Eurozone inflation data will be released next week, providing the final basis for the September interest rate decision.

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