Recent survey data indicates that the Eurozone's manufacturing growth momentum weakened significantly in May, driven by supply chain disruptions from Middle East conflicts and input costs reaching a four-year high. Concurrently, inflation in core economies like France and Spain has climbed to its highest levels in 2024, compelling the European Central Bank to reassess its monetary policy stance.
Markets widely anticipate that to curb the pass-through of energy prices into core inflation and prevent inflation expectations from becoming unanchored, the ECB will restart its interest rate hiking cycle at its June policy meeting.
Manufacturing Expansion Slows as Cost Pressures Hit Four-Year Peak
Data released by S&P Global on the 1st shows the final reading for the Eurozone's May Manufacturing Purchasing Managers' Index (PMI) was 51.6. While this is above the preliminary estimate of 51.4, it marks a notable decline from April's 52.2, which was near a four-year high. The index has remained above the 50-point expansion/contraction threshold for a fourth consecutive month, indicating factory activity is still growing, but the pace has clearly lost steam.
Stagnant demand was the primary drag on the index. The new orders index stalled in May, and export orders also declined, a stark contrast to April's four-year high growth rate driven by consumer stockpiling. On the output side, the factory output index fell from 52.3 in April to 51.3, its lowest level since January. Employment numbers have now declined for three consecutive years.
Chris Williamson, Chief Business Economist at S&P Global Market Intelligence, noted that while manufacturing activity continues to expand, the sector is struggling under the weight of price increases and supply disruptions stemming from the Middle East conflict. The survey shows manufacturers' input costs rose at the fastest annual pace since May 2022, driven by soaring energy and raw material prices; firms are raising their selling prices at the fastest rate in three-and-a-half years to pass on these burdens. Supply chain delays have also worsened to the most severe level since June 2022.
Williamson warned that high prices are dampening demand, and the pass-through of costs will inevitably drive inflation higher in the coming months. Policymakers now face a difficult balancing act: curbing resurgent inflation while avoiding aggressive rate hikes that could further stifle already weak demand.
Rising Risk of Unanchored Inflation Expectations Bolsters Hawkish Signals
A monthly survey published by the European Central Bank on the same day showed that while respondents' three-year-ahead inflation expectations edged down to 2.9% from 3.0% in March, expectations for inflation one year ahead remained stubbornly at 4.0%, and five-year expectations held at 2.4%. All these figures are above the ECB's 2% medium-term target.
ECB Executive Board member Isabel Schnabel explicitly stated in a speech at a Bank of Korea conference in Seoul on Monday that the inflation impact from the Iran conflict can no longer be ignored. She emphasized that damage to energy infrastructure and global supply chains has durably altered price dynamics, and policymakers may need to react even if the conflict ends immediately. "The risk of inflation expectations becoming unanchored is rising," said Schnabel, who is viewed as one of the ECB's most hawkish officials.
Schnabel pointed out that the current shock differs from past energy crises, increasingly resembling a global demand shock that raises production costs everywhere via global supply chains. These remarks have further strengthened market expectations for a rate hike at the policy meeting on June 10-11.
France and Spain Lead Inflation Surge, June Rate Hike Probability Exceeds 90%
As leading indicators for price reports in major Eurozone economies, May inflation data from France and Spain both exceeded expectations. Latest figures show French CPI rose 2.8% year-on-year in May, a near two-year high. Spanish CPI increased 3.6% year-on-year, setting a new record for 2024. Soaring energy prices, particularly for natural gas and fuel, remain the core driver. Additionally, Spanish government tax relief measures for the energy crisis are set to expire on May 31, with the VAT rate reverting to the standard 21%, seen as an additional shock on top of high energy prices.
Financial markets have already priced in a rate hike. Swap market data suggests a roughly 90-91% probability that the ECB will raise its deposit rate by 25 basis points to 2.25% on June 11. Analysis from institutions like Societe Generale indicates markets have fully priced in two rate hikes within 2026, with about a 50% probability of a third move.
Alexander Stott, European Economist at Goldman Sachs, stated that the transmission of tighter policy is already underway, with a notable tightening of bank lending standards. This somewhat reduces the necessity for aggressive tightening, supporting the case for the central bank to proceed with a cautious pace of rate hikes.
"Stagflation" Clouds Gather, Constraining Policy Options
As inflation heats up, the Eurozone's economic growth outlook is dimming. Revised data shows French GDP contracted 0.1% quarter-on-quarter in Q1, with consumer confidence hitting a three-year low. The Eurozone's overall GDP growth is forecast to slow from 1.4% in 2025 to 0.9% in 2026. Holger Schmieding, Chief Economist at Berenberg Bank, believes the three largest economies—Germany, France, and Italy—are being weakened by surging energy costs, creating a classic "stagflation" environment.
Divisions remain within the ECB regarding the future path. Vice President Luis de Guindos emphasized there is no predetermined course for interest rates, and decisions will be assessed meeting-by-meeting. Lithuanian Central Bank Governor Gediminas Šimkus suggested a second rate hike is "quite likely," though the timing is uncertain.
Philippe Alloatti, Head of Financials Credit at Federated Hermes, pointed out that the ECB's credibility is being tested, and any hesitation could undermine confidence in its ability to maintain price stability.
With the Middle East situation continuing to impact global energy markets, Brent crude oil futures have recently been highly volatile, trading in a range of $94 to $97 per barrel. Analysts note that if oil prices remain elevated and inflation expectations become entrenched, Europe may be forced into a more aggressive tightening cycle than markets currently anticipate. Beyond the global AI boom, energy and geopolitical risks are re-emerging as core variables influencing global financial markets.
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