Stagflation risks are fading

The euro area outlook suddenly looks a bit less stagflationary. Against a backdrop of sharp retracement in crude oil prices, the recent data flow points to a degree of economic resilience and limited signs of broadening inflation pressures. 

On inflation, the headline rate eased from 3.2% to 2.8% Y/Y in the flash estimate for June, comfortably below the consensus expectation (3.0%). The energy component slipped back (from 10.8% to 8.7%) on falling pump prices, as expected. But there were also signs of broad-based easing beyond energy. The services rate decreased by 0.3pp to 3.2%. Disinflation in the food component continued, edging down to 1.0% Y/Y. Core goods inflation remained steady at 0.9% Y/Y. The final release (17 July) will provide more details but there is still scant evidence of inflation pressures broadening beyond direct energy effects.

The growth backdrop also looks a little more resilient. The composite PMI for June was revised up to the breakeven mark of 50 today. Hard data in Q2 has looked relatively firm with industrial output holding up well in the national releases so far and German retail sales at 1.1% M/M in May. We are currently tracking Q2 euro area aggregate growth at 0.25%, which would be a good outcome in the context of higher energy pricing and Hormuz-related uncertainty (we had initially pencilled in flat growth, i.e. 0.0%). Looking further back, the Q1 contraction may well be revised away as well after the estimate for ever-volatile Irish growth was lifted from -12.1% to -7.0% Q/Q.

We see the sweeping reform package announced this week by the German government as positive for the outlook too. Income tax relief from January 2027 will provide a short-term growth boost. Near-term business sentiment could also be lifted. Firms have been calling out for exactly the sort of supply-side reforms to increase labour market flexibility and streamline regulation which have been announced.  

Data yesterday also showed the euro area unemployment rate slipped back to its historical low (6.2%), which adds to the sense that the euro area economy has managed to navigate the latest energy shock in reasonable shape.

There is a bit more inflation in the pipeline – but May might have marked the peak

On the outlook for inflation, we expect the shock will continue to pass through to prices. Temporary government support measures (e.g. on fuel taxes in Germany and Italy) are ending, which will offset some of the impact from the collapse in oil prices. While the rise in wholesale gas prices was relatively moderate, levels remain above pre-conflict marks and costs will gradually pass through to household utility bills. Meanwhile, we expect core goods prices will start to reflect upward pressure from transportation and material costs, and the food disinflation story will be challenged by the impact of both unusually hot weather in Europe and higher fertiliser costs. The services component could also tick higher on air fares during the peak summer months.

Putting it all together, we see enough pipeline pressures to offset the fall in pump prices. We expect headline inflation will drift higher over coming months towards the 3.2% May peak – but it is unlikely to move much above that mark if current energy pricing is maintained. We put the 2026 annual average rate at 2.8%. The negative contribution of energy from March 2027 is then likely to bring rates back down to target. However, it’s set to be a slower grind down for underlying inflation as higher energy costs percolate through to non-core components.

We continue to expect another ECB hike – but it’s a closer call

What does this all mean for the ECB? Collapsing energy prices and the downside inflation miss have seen a repricing of market rate expectations. Less than 20bp of tightening this year is currently priced. The hawks are clearly on the back foot. But our view remains that conditions will allow the ECB to deliver one final 25bp hike, to 2.50%, in September.

As things stand, the ECB is set to revise down its headline inflation projections in September. Yet we suspect the case for tightening again will be supported by fresh projections in September showing a persistent overshoot in the core rates. The ECB’s latest ‘Milder’ scenario, which is based on energy pricing close to current forwards, had core slightly above target in 2028. Those projections were conditioned on market pricing consistent with 2-3 hikes this year. The September update will likely be conditioned on a somewhat lower policy-rate path, which should provide at least a partial offset to energy price developments.

We also continue to highlight comments from ECB Chief Economist Philip Lane suggesting that the neutral rate could now be as high as 2.50% (see here: The ECB reopens the debate on neutral). Lagarde mentioned “structural pressures that include rising defence spending” in a speech this week. The possibility of an upward shift in the neutral rate will bolster the argument that rates need to be raised further to sufficiently lean against inflation risks.

More ECB-speak and German industrial data

It looks set to be a relatively quiet week ahead. The ECB will release its minutes of the June meeting on Thursday. There will also be a flurry of ECB and speakers, but we imagine the messaging will be similar to what we’ve heard this week at Sintra (i.e. the June hike was ‘robust’, inflation risks have since become more balanced, but policymakers will continue to watch the data closely without any pre-commitment). In terms of data, it will be a light schedule. We will be focused on German industrial figures (factory orders and production) which will provide a clearer steer on Q2 growth prospects.