Europe's economy is caught in a stagflationary grip, as first-quarter growth nearly halted at 0.1% while inflation unexpectedly climbed to 3 percent, complicating the path forward for central banks.
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Eurozone economy stalls with 0.1% growth as inflation hits 3%
The specter of stagflation is haunting Europe after the economy nearly flatlined in the first quarter and inflation accelerated, leaving central banks with a difficult choice between supporting growth and containing prices. The eurozone economy grew by just 0.1% in the first quarter compared with the end of 2025, according to Eurostat, while consumer prices in April rose a faster-than-expected 3% from a year earlier.
"What is critically important is the impact energy prices will have," European Central Bank President Christine Lagarde said Thursday after the bank held interest rates steady.
The data paints a grim picture for the continent. The inflation surge was driven by an 11 percent year-over-year increase in energy prices, a direct consequence of the ongoing war in the Middle East and the effective blockade of the Strait of Hormuz. This has hit Europe, a major energy importer, particularly hard. In Germany, the bloc's largest economy, retail sales fell 2.0% month-over-month in March, the biggest decline in over three years, showing the strain on consumers.
The mix of feeble growth and soaring inflation puts the ECB and the Bank of England in a bind. Both central banks, along with the U.S. Federal Reserve, kept borrowing costs on hold this week. However, policymakers in Europe are signaling that rate hikes could come this summer to prevent high energy costs from feeding into a broader wage-price spiral. Markets are now pricing in between two and three rate increases by the ECB and BoE this year, according to LSEG data. This policy tightening into a weak economy raises the risk of a recession.
Central Banks on a Knife's Edge
Before the conflict, Europe's economy was poised for a rebound, with inflation returning to the ECB's 2% target. The central bank now forecasts growth of just 0.9% for the year, a forecast Lagarde warned might be too optimistic. In a more severe scenario where energy disruptions persist, the ECB estimates growth could slow to just 0.4%.
"There has been enough of an inflationary impulse in the system to have closed the window for central banks to simply look through the shock," said Paul Hollingsworth, an economist at BNP Paribas. "We think they will have to respond to that over the coming quarters."
The market reaction has been telling. While the Euro Stoxx 50 index showed resilience, climbing 0.72%, government bond yields moved lower, a sign of economic pessimism. The 10-year German bund yield fell 8.1 basis points to 3.029%, retreating from a 15-year high. The ECB and BoE have made it clear they are watching wage negotiations closely for signs of "second-round effects," which would almost certainly trigger a policy response despite the fragile growth outlook. The next ECB policy meeting is on June 11.
This article is for informational purposes only and does not constitute investment advice.
