The central bank is contending with rising prices, the consequences of the U.S.-Iran war and surging government borrowing costs.
The European Central Bank has voted to raise its key deposit rate by 25 basis points to 2.5% from 2.25% in a move widely expected by investors.
But uncertainty around the U.S.-Iran war continues to cloud the outlook for the ECB's longer-term policy path, market watchers say, and investors will be watching closely for signals in policymakers' remarks later on Thursday.
The ECB expects baseline inflation, excluding energy and food, to reach 2.5% in 2026, 2.6% in 2027 and 2.3% in 2028.
ECB president Christine Lagarde warned that the conflict in the Middle East and recent developments in Russia's war on Ukraine will keep headline inflation "well above target" the bank's 2% target for an extended period.
Lagarde said in a press conference immediately following the rate hike that despite the "greater-than-expected resilience" shown by the euro zone economy, the energy price shock, as well as global trade tensions, remain a risk to growth.
"The outlook remains highly uncertain, with risks to the upside for inflation and to the downside for economic growth," the ECB's Governing Council said, acknowledging a "broad range of outcomes" around growth and inflation as a result of the energy shock, including duration and second-round effects.
Markets priced in a 100% chance of the 25 basis points hike ahead of Thursday's meeting, according to LSEG data.
ECB officials have said since the U.S.-Iran war broke out that they would take a meeting-by-meeting approach to monetary policy. The central bank's rates-setting Governing Council will hold a press conference in Berlin, scheduled for 8:45 a.m. E.T., following the decision.
The move comes days after data showed inflation in the euro zone hit 3.3% in August, with energy inflation surging to 14.3%.
The euro zone, a net importer of energy, has seen inflation above the ECB's 2% target since the war in the Middle East threatened commodity transit through the Strait of Hormuz, causing oil prices to spike and remain volatile .
Government borrowing costs have also risen drastically in recent weeks, with European bond yields hitting multi-decade highs as intensifying conflict in the Middle East led investors to price in higher inflation and rate hikes.
Investment strategists said the decision indicates further rate rises are now likely.
Ed Hutchings, head of rates at Aviva Investors, said the outlook for inflation remains a "significant source of concern" for the Governing Council and investors alike.
"It's clear more hikes will be coming, and potentially more than one," Hutchings said. "The immediate priority for the ECB is clear: address the inflationary backdrop, and, as such, the market is right in thinking more hikes will be coming. However, with two hikes already being delivered and more than a further two hikes priced, things may well have gone too far."
Patrick Ernst, macro investment strategist, JP Morgan Private Bank, said the rates trajectory now hinges on the uncertain geopolitical backdrop.
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