The current tensions in the Middle East have reignited a familiar concern in Europe: that energy might once again become a source of macroeconomic vulnerability. With every escalation, oil prices rise, sovereign bond yields react and financial markets revise their expectations. In recent weeks, the markets have even priced in two or three interest rate hikes by the European Central Bank (ECB) by the end of 2026, with the first hike as early as June.
These financial market expectations say a great deal about investor sentiment, but far less about the economic reality in Europe. Indeed, this market reaction primarily reflects a geopolitical risk premium – a way for the markets to protect themselves against uncertainty – rather than a genuine shift in the inflation trend within the eurozone.
Inflation is not yet sustainable
The current energy shock, whilst serious, does not yet have the inflationary nature that some fear. This type of shock primarily affects price levels rather than the inflation rate. This distinction is crucial. This is precisely what the latest forecasts from the OECD, and also from the ECB, show; these forecasts partly factor in the effects of the current conflict. These institutions anticipate inflation of 2.6% in 2026 – a slight upward revision – but, more importantly, core inflation remaining around 2.3%, before returning to 2% in 2027. Based on current data and trends, this is therefore more of a price shock than a self-sustaining inflationary dynamic.
Recent comments from certain ECB members point in the same direction. Indeed, the ECB must continue to be guided by economic data rather than by market volatility. This is all the more true if the current shock stems more from a risk premium than from internal dynamics. What matters are second-round effects, i.e. the transmission of an initial price rise (e.g. an energy shock) to other components of inflation, thereby fuelling more persistent inflation. These remain remarkably contained. Medium-term inflation expectations have also not shifted significantly.
The structural fragility of the European economy
The other key factor is the structural fragility of the European economy. After several years of successive shocks, the eurozone is more indebted, more sensitive to interest rate fluctuations and more vulnerable to financial stress.
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 territory in April, dragged down by a very sharp decline in services. Manufacturing is holding up, but only thanks to precautionary stockpiling linked to geopolitical risks. Input costs are rising, but against a backdrop of weakening demand. In such a context, a rate hike would have a swifter and deeper impact, which explains why some ECB members are reluctant to react impulsively to this shock.
Markets versus the economy
Why, then, are the markets anticipating so many rate rises – and, above all, a rise as early as June? Because they react differently from the real economy. Markets tend to overreact before returning to fundamentals. Today, every rise in oil prices is interpreted as a lasting signal, every geopolitical tension is blown out of proportion, and every hesitation on the part of the ECB is seen as a sign of future resolve. For a rate hike to take place as early as June, several conditions would need to be met. In particular, credible signs of second-round effects, meaning a significant rise in core inflation. Although this week’s PMI figures have reignited the debate, recent economic data do not justify immediate action by the ECB. The baseline scenario therefore remains that of a wait-and-see ECB. However, a rate hike – which could be described as a one-off – remains plausible to preserve the institution’s credibility should inflation expectations begin to rise.
