The European Central Bank is facing its most difficult policy decision since the 2022 energy crisis as eurozone inflation climbed to 3.0% year over year in April while the economy contracted at the fastest pace since late 2023. The combination of rising prices and falling output has reignited stagflation fears across the continent and forced markets to price in a dramatic policy reversal -- from rate cuts to rate hikes -- for the first time since 2024.
Markets now assign a 76% probability to a 25 basis point rate hike at the ECB's June meeting, which would raise the main refinancing rate from 2.15% to 2.40%. A Bloomberg survey of economists expects two quarter-point hikes in 2026, in June and September, marking a stunning reversal from January when three rate cuts were the consensus forecast.
What happened
Eurostat reported that harmonized consumer prices in the eurozone rose 3.0% year over year in April, up from 2.6% in March and well above the ECB's 2% target. Energy prices were the primary driver, surging 14.2% as the Iran conflict pushed natural gas and refined fuel costs sharply higher across Europe. Core inflation -- excluding energy, food, alcohol, and tobacco -- held at 2.4%, but services inflation accelerated to 3.8%.
Simultaneously, the S&P Global flash PMI for May showed the eurozone composite index falling to 48.9 from 50.4 in April, indicating economic contraction. Manufacturing remained deeply in recession at 45.2, while services slipped below the 50 expansion threshold for the first time since February. The divergence between rising prices and falling output is the textbook definition of stagflation.
Why it matters
The ECB has been on a rate-cutting path since mid-2024, reducing rates from a peak of 4.0% to 2.15% as inflation appeared to be converging toward target. The Iran-driven energy shock has reversed that progress and forced the central bank to reconsider its entire policy stance. A rate hike in June would be the first increase since September 2023 and would signal that the ECB prioritizes inflation control over growth support.
For the broader euro area economy, the timing is painful. Germany's manufacturing sector continues to struggle, France faces political uncertainty, and peripheral economies are grappling with elevated debt costs. A rate hike into a contracting economy risks deepening the downturn, but allowing inflation expectations to de-anchor could create even worse outcomes.