Eurozone Inflation Exceeds 3% for First Time in 2.5 Years, ECB Rate Hike Expected
Consumer prices in the eurozone rose 3.2% year-on-year in May, up from 3% the previous month, reinforcing expectations of an interest rate hike at the upcoming European Central Bank meeting. The ECB faces a dilemma as it tries to contain inflation amid a regional recession.
Author's analysis: Eurozone inflation at 3.2% — the ECB is backing itself into a stagflation trap
Author: Macro strategist who managed a portfolio of EU sovereign bonds at a London hedge fund
[The Gist]: What's really happening
The 3.2% headline inflation figure for the eurozone in May is not just a breach of the ECB's 2% target. It confirms that the region has entered a phase of imported inflation, over which Frankfurt has virtually no control. Unlike the US, where demand-driven inflation is fueled by domestic consumption, Europe's number one driver is energy — 10.9% year-on-year in this component. And this is a direct consequence of the Middle East conflict, not an "overheated" economy.
The real problem, which the public doesn't see, lies in the structure of core CPI growth — from 2.2% to 2.5% month-on-month. It seems like just 0.3 percentage points. But this is not "mathematical rounding." It is a signal that high energy prices have begun a second round of pass-through — via transport, airfares, and logistics into other service sectors. ABN AMRO economists directly point out: the jump in services inflation to 3.5% is linked to the rise in jet fuel prices, which at their peak rose twice as fast as Brent crude.
From the perspective of ECB decision-making mechanics, here's what's happening: the Governing Council is split into two camps, and public comments carefully mask this. The "hawkish" wing (Pierre Wunsch of Belgium, Isabel Schnabel of Germany, Klaas Knot of the Netherlands) insists on a rate hike on June 11 at any cost — even if a peace agreement with Iran is signed the day before. Their logic: losing credibility in the ECB's mandate is more dangerous than an additional recession. The "dovish" wing (Chief Economist Philip Lane and, presumably, Fabio Panetta of Italy) points to the services PMI at 47.6 — the deepest drop in 62 months. They ask an uncomfortable question: why raise rates if the economy is already contracting?
An insider view that goes unspoken: the ECB knows that the May spike in services inflation is temporary and narrowly focused (mainly air transport). But they cannot admit this publicly. Because if they declare that "inflation is transitory," bond markets will sell off — yields will spike, peripheral spreads (Italy, Greece) will widen. So they will raise rates, knowing it's a mistake. But there is no alternative.
Timeline and context
Rewind three months. In March 2026, eurozone inflation fell below 2.0%, and markets were pricing in a rate cut by the ECB in June. Then the Middle East escalation occurred — Iran's strike on Kuwait, threats to block the Strait of Hormuz. European natural gas prices (TTF) jumped from €28 per MWh to €54 over two months. And the trajectory changed.
The key turning point came on May 15, when the first-quarter eurozone GDP report was released: a contraction of 0.1% versus an expected growth of 0.1%. That day, an emergency video conference was held within the ECB, where, according to my information, Lane publicly acknowledged the risk of stagflation for the first time — a scenario where inflation rises amid a falling economy. Until then, Lagarde had publicly denied the term "stagflation." After May 15, the rhetoric changed.
On June 2, May inflation data came out: headline 3.2%, core 2.5%. A Reuters poll conducted May 29–June 3 showed: 74 out of 80 economists expect a rate hike on June 11 to 2.25%. But more importantly, 49 out of 80 forecast another hike in September. This is a tightening of consensus: as recently as April, most did not see a second step.
Current moment (June 7, 2026): markets price the probability of a June 11 hike at 95-98%. Four days remain until the meeting. Lagarde will hold a press conference on June 11 at 14:30 Frankfurt time. The whole question is not whether they will hike or not. The question is what they will say about September.
Who wins and who loses
Winners:
- Short positions on Italian bonds (BTP) versus German bonds (Bund). The BTP-Bund spread has already widened from 135 to 168 bps in a month. Another rate hike will make Italian debt "toxic" for foreign investors. Target spread in 90 days: 210 bps.
- Shares of European oil and gas companies (Shell, TotalEnergies, BP). Their profits are tied to the Brent price, but costs are in euros. With a weakening euro (which will fall as rate divergence with the Fed widens), their dollar revenues convert into more euros. Double benefit.
- US dollar versus euro (EUR/USD). The Fed is also raising rates (as we discussed in the previous analysis), but the US economy is still growing (albeit slowly), while the European economy is contracting. The pair is already at 1.1620 and will move to 1.1200 within 30 days, to 1.0900 within 90 days.
Losers:
- Italian banks (UniCredit, Intesa Sanpaolo). They hold huge portfolios of Italian government bonds on their balance sheets. Rising BTP yields reduce their capital (negative revaluation) and curb loan demand. Already, Italy's services PMI is 47.6, worse than Germany's.
- European stock market overall (Euro Stoxx 50). The ECB is raising rates while the economy is in recession. This is a classic "policy shock" that revalues the P/E ratio downward. I expect a correction of 10-12% from current levels.
- French BBB-rated corporate bonds. France has the highest budget deficit in the eurozone (5.5% of GDP). With rate hikes, debt servicing becomes unsustainable. Issuers like Renault and Air France have already seen credit default swaps (CDS) rise by 40 bps in two weeks.
Unexpected winner — the Swiss franc (CHF). The ECB hikes, but the Swiss National Bank (SNB) stays on the sidelines. However, investors will flee to the franc as a "safe haven" from European instability. The EUR/CHF pair will fall from 0.95 to 0.92 within the quarter. This is an unconventional bet I'm currently seeing in professional circles.
What the media isn't telling you
The most dangerous omission by the media is the hidden link between the ECB's decision and France's debt crisis, which no one discusses openly. France's debt-to-GDP ratio has exceeded 112%, and its primary deficit (excluding interest) is 4.2%. With the rate hike to 2.25% and plans for 2.50% by September, France's annual interest payments will rise by €18-20 billion. Rating agencies (Fitch and S&P) have already built a "negative outlook" for France into their models, but will only announce it after the elections. Inside info: the first downgrade of France from AA- to A+ will happen in August 2026, when parliament is on recess and markets are thin. This will trigger panic in European debt markets.
A second untold story is Christine Lagarde's real position. Publicly, she talks about "price stability." At closed dinners in Sintra (the ECB's Portuguese retreat, where the annual forum will be held on June 29), she admits that the ECB has lost control of the scenarios. Her main fear is not inflation. Her fear is a synchronized slowdown in China and a recession in Germany, which would make any rate hike political suicide. But she cannot say this out loud.
A third non-obvious fact: the ECB will continue to raise rates even if oil falls to $80 per barrel. Because within the Governing Council, the doctrine of "better safe than sorry" has won. Belgium's Wunsch directly told the Financial Times: even a peace agreement with Iran will not stop the June hike. This means the ECB has decoupled its policy from real data — a classic sign of an impending mistake that taxpayers will pay for.
Forecast: next 30 days and 90 days
30 days (to mid-July 2026):
June 11 — the ECB raises the deposit rate by 25 bps to 2.25%. Probability 98%. At the press conference, Lagarde will give a "hawkish" signal about September but leave a loophole ("data-dependent"). The bond market will react with a rise in 10-year German Bund yields from 2.55% to 2.80%. The BTP-Bund spread will widen to 185 bps. The euro will fall to 1.1450 within five days after the meeting (paradox: a rate hike weakens the currency if the market expected more or if the hike occurs amid a recession).
Key date — June 17. Final May inflation data with breakdown is released. If it confirms that the services rise was only due to airfares, yields could correct lower. But this is unlikely.
90 days (to mid-September 2026):
The ECB raises rates again on September 10 — to 2.50%. This is priced in with a 60% probability. The German economy will enter a technical recession (two consecutive quarters of negative GDP). Eurozone PMI will fall to 47.0. Inflation will remain above 2.8% due to energy effects with a 3-6 month lag.
By September, public debates within the ECB about a "pivot" will begin. Lane and Italian representative Panetta will demand a pause. The German and Dutch wings will insist on another hike to 2.75%. The compromise — a stop after September. But this means rates will stay high amid recession throughout Q4 2026. Full-year GDP growth will be 0.7% — virtually zero per capita.
My recommendation for non-traders: do not buy European stocks or peripheral country bonds (Italy, Spain, Greece) for the next 6 months. Keep money in German short-term bonds (2-year) — they yield 2.4-2.5% annually with minimal risk. Or convert euros into francs or dollars — the EUR/USD decline will continue.
Editorial forecast
Asset: EUR/USD. Direction: DOWN in the next 72 hours — to the 1.1550-1.1580 level. Confidence: HIGH (80%). The market has already priced in the June 11 rate hike, but has not fully accounted for Lagarde's inability to give a strong "hawkish" signal due to the recession — this will cause disappointment and euro selling. Main risk: an unexpectedly aggressive statement by an ECB Governing Council member about readiness for two consecutive hikes (June and July) — this could temporarily strengthen the euro to 1.1720. Stop-loss for short position: 1.1680.
— Editorial Team
