The current tensions in the Middle East have reignited a familiar concern in Europe – the fear of energy becoming a factor of macroeconomic vulnerability. With each escalation, oil prices rise, sovereign rates react, and financial markets adjust their expectations. In recent weeks, the markets have even priced in two to three ECB rate hikes by the end of 2026, with the first hike expected as soon as June.
These market expectations reveal much about investor sentiment but less about the actual economic reality in Europe. This market reaction mainly reflects a geopolitical risk premium, a way for markets to protect themselves against uncertainty, rather than a genuine change in the inflation trend in the eurozone.
Context: The article discusses how market reactions to the tensions in the Middle East are impacting European economies.
Fact Check: The article emphasizes that the current situation is more about a risk premium rather than a sustained inflationary trend in the eurozone.
A Not Yet Enduring Inflation
The current energy shock, while serious, has not yet taken on the inflationary nature that some fear. This type of shock primarily affects price levels rather than inflation rates. This distinction is crucial. The latest OECD and ECB forecasts show an anticipated inflation rate of 2.6% in 2026, slightly revised upwards, but with underlying inflation contained around 2.3%, before returning to 2% in 2027. Based on current data and trends, this is more of a price shock than a self-perpetuating inflation dynamic.
Recent statements from some ECB members echo this sentiment. The ECB must be guided by economic data rather than market volatility. This is especially true if the current shock is more of a risk premium than an internal dynamic. The focus should be on second-round effects, such as the transmission of an initial price increase (e.g., energy shock) to other inflation components, fueling a more enduring inflation. However, these effects remain remarkably contained, and medium-term inflation expectations have not changed much.
The Structural Fragility of the European Economy
Another crucial factor is the structural fragility of the European economy. After several years of consecutive shocks, the eurozone is more indebted, more sensitive to interest rate fluctuations, and more vulnerable to financial tensions.
Growth forecasts remain very modest. This week’s flash PMI figures confirm this view of a fragile eurozone. The composite index plunged back into contraction in April, mainly due to a sharp decline in services. The industry is holding up, but relies heavily on precautionary stocks linked to geopolitical risks. Input costs are rising, but in a context of weakened demand. In such a scenario, a rate hike would have a quicker and more profound impact, explaining the caution of some ECB members in reacting to this shock.
Markets vs. Economy
Why then do markets anticipate so many rate hikes and especially one as early as June? Because they react differently from the real economy. Markets tend to overreact before returning to fundamentals. Today, every oil price increase is seen as a lasting signal, every geopolitical tension is extrapolated, every hesitation from the ECB is seen as a sign of future firmness. For a hike to occur as early as June, several conditions should be met, including credible signs of second-round effects, i.e., a significant increase in underlying inflation. Even though this week’s PMI figures reignite the debate, recent economic data do not warrant an immediate action by the ECB. The base scenario currently remains one of a patient ECB. However, an isolated rate hike to maintain the institution’s credibility is still plausible if inflation expectations were to tighten further.
