Stagflation clouds loom! Eurozone inflation soared to 3% in April, putting pressure on the ECB to raise interest rates in May.

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The Eurozone’s economy was nearly stagnant in the first quarter, while the inflation rate unexpectedly jumped to 3% in April, turning the risk of stagflation from a warning into reality. Facing the pressure from soaring energy costs, the European Central Bank decided on Thursday to keep interest rates unchanged, in line with market expectations, but this further exposed its policy dilemma between curbing inflation and supporting growth.

According to the latest data released by Eurostat, the Eurozone’s GDP grew only 0.1% quarter-on-quarter in the first quarter this year, with economic activity almost at a standstill. Meanwhile, the Consumer Price Index (CPI) rose 3% year-on-year in April, not only higher than March’s 2.6% but also marking the fastest pace since September 2023.

The main driver behind accelerating inflation is energy: Energy prices surged 10.9% year-on-year in April, compared to 5.1% in the previous month. Currently, the Eurozone inflation rate has significantly exceeded the ECB’s target of 2%. As price pressures continue to heat up, market expectations for a rate hike by the ECB at its May meeting are rising rapidly.

The issue is that if the ECB raises interest rates to curb inflation, it will likely further drag down the already weak economic fundamentals. More severely, the main cause of this round of inflation—surging energy prices amid the Middle East conflict—has gone beyond the direct influence of monetary policy, making it difficult for the ECB’s policy tools to address the problem.

Middle East conflict delivers a "blow" to Europe's economy

The continued blockade of the Strait of Hormuz remains a major concern for Europe. Amid heightened demand and competition, Europe is scrambling to source oil, natural gas, and aviation fuel from suppliers outside the Middle East. In a warning email last week, Berenberg economists stated that the shock waves of the Iran war are now “hitting European economies.”

They pointed out, “As long as the Strait of Hormuz remains basically closed and widespread uncertainty continues to dampen confidence, the Eurozone and UK could suffer a bout of stagflation. Even if the worst phase of the war ends by late April, Europe’s growth this year will be below last year’s level.”

“The outlook thereafter will largely depend on the ECB. In our view, inflation risks are much milder than in 2022... However, if the ECB raises rates to respond to the temporary inflation surge, the Eurozone could fall into an unnecessary minor recession by late 2026 or early 2027, before the economy can start to recover from policy mistakes,” they concluded. “Hopefully, the ECB can remain on hold this year.”

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