ECB warns markets underestimate risks as inflation may hit 4.4%

The ECB sees complacency in markets that could unravel if Middle East disruptions push eurozone inflation past 4%.

The European Central Bank warned investors are underestimating risks from the Middle East conflict and rising government debts, saying stretched asset prices leave markets vulnerable to a sharp repricing even as inflation could climb to 4.4%.

"Despite initial declines, financial asset prices still look stretched by historical standards, all the more so when current geoeconomic stress and uncertainty are taken into account," Luis de Guindos, the ECB's vice president, said in the bank's semi-annual Financial Stability Review published Wednesday.

The ECB held its deposit rate at 2% at its April 30 meeting after a cutting cycle through 2025. Its baseline projection for 2026 inflation stands at 2.6%, above the 2% target, but adverse scenarios tied to the conflict — which intensified in February 2026 — show inflation surging to between 3.5% and 4.4%, depending on how disruptions at the Strait of Hormuz evolve. Roughly a fifth of the world's oil passes through the chokepoint daily.

The warning matters because the transmission mechanism for monetary policy is less effective against supply-driven shocks. ECB Chief Economist Philip Lane said May 13 that the current energy supply disruptions are "qualitatively different" from prior episodes, as conventional rate tools struggle to absorb price pressures originating from a single strategic chokepoint. If Lane's worst-case scenarios materialize, the 2% deposit rate is unlikely to hold, and markets that had been pricing in further cuts will need to recalibrate.

The ECB's assessment comes as euro area firms report higher expected input costs and elevated short-term inflation expectations, according to the bank's own surveys. Market moves in response to the conflict have been "orderly," the ECB said, but continued to reflect complacency in the face of increased uncertainty about the economic outlook.

Stretched Valuations Meet Fiscal Stress

Financial asset prices across the eurozone remain elevated by historical measures even after initial declines triggered by the conflict, the ECB said. The warning extends beyond geopolitics to fiscal risks: rising government debt loads across the bloc compound the vulnerability, as higher borrowing costs would strain sovereign balance sheets already stretched by years of crisis spending. The last time the ECB used language this pointed about market complacency was in its December 2023 Financial Stability Review, which preceded a 6% correction in the Euro Stoxx 50 over the following two months.

The Energy Transmission Chain

The conflict's impact on energy markets is the primary channel through which financial stability risks propagate. The Strait of Hormuz, through which roughly 20% of global oil supply transits daily, represents a concentration risk that the ECB said is not fully priced into risk assets. Energy price increases have already pushed the ECB's 2026 inflation forecast to 2.6%, and each incremental disruption adds upward pressure. Eurozone government bond yields have risen as the inflation outlook deteriorates, while the euro has weakened against the dollar on terms-of-trade concerns, creating a cross-asset dynamic that the ECB said warrants close monitoring.

The ECB's next policy decision is scheduled for June 11, when updated staff projections will show whether the baseline inflation forecast has shifted. OIS markets currently price the deposit rate remaining at 2% through the third quarter, but the adverse inflation scenarios outlined by Lane suggest that path is contingent on energy markets remaining stable. If the Strait of Hormuz faces actual disruption, the calculus changes — and the complacency the ECB identified Wednesday would be tested.

This article is for informational purposes only and does not constitute investment advice.