The eurozone economy neared stagnation in the first quarter, while the April inflation rate unexpectedly surged to 3%, indicating that the risk of stagflation is shifting from a warning to reality. Faced with pressure from soaring energy costs, the European Central Bank (ECB) decided on Thursday to keep interest rates unchanged, aligning with market expectations, yet further exposing its policy dilemma between curbing inflation and supporting growth.
According to the latest data from Eurostat, the eurozone's GDP grew by a mere 0.1% quarter-on-quarter in the first quarter of this year, indicating nearly stagnant economic activity. At the same time, the Consumer Price Index (CPI) rose by 3% year-on-year in April, surpassing both the 2.6% rate recorded in March and marking the fastest increase since September 2023.
The primary driver of accelerating inflation stems from energy: energy prices surged by 10.9% year-on-year in April, compared to a 5.1% rise in the previous month. The current inflation rate in the eurozone is now significantly above the ECB's 2% target level. As price pressures continue to intensify, market expectations for an ECB rate hike at its May meeting are rapidly increasing.
The challenge lies in the fact that if the ECB raises interest rates to curb inflation, it could further weaken an already fragile economic foundation. More critically, the main cause of this round of inflation—the surge in energy prices against the backdrop of Middle East conflicts—falls outside the direct influence of monetary policy, making it difficult for the ECB's policy tools to address the root cause effectively.
The ongoing blockade of the Strait of Hormuz remains a significant concern for Europe. Amid heightened demand and competition, European nations are scrambling to procure oil, natural gas, and jet fuel from suppliers outside the Middle East. Economists at Berenberg warned in a recent email alert that the shockwaves from the Iran conflict are now "impacting European economies."
They pointed out that "as long as the Strait of Hormuz remains largely closed and widespread uncertainty continues to undermine confidence, the eurozone and UK economies could face a period of stagflation. Even if the worst phase of the conflict ends by late April, Europe's growth this year will likely be lower than last year's levels."
"The outlook beyond that will largely depend on the ECB. In our view, inflation risks are considerably milder compared to 2022... However, if the ECB raises rates in response to a temporary inflation spike, the eurozone could experience an unnecessary minor recession by late 2026 or early 2027, before the economy begins to recover from the policy misstep," they concluded. "It is to be hoped that the ECB will maintain its current stance this year."
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