NextFin News - Business activity across the euro area contracted at its steepest rate in two and a half years this May, as the escalating conflict in Iran and a subsequent surge in energy prices crippled manufacturing and stalled the services sector. The flash Purchasing Managers’ Index (PMI) for the 20-nation bloc fell to 46.8, down from 49.2 in April, marking the lowest reading since late 2023 and defying economist expectations for a modest recovery.
The data highlights a deepening stagflationary trap for the European Central Bank (ECB). While the manufacturing sector has been in a prolonged slump, the services sector—previously the economy’s primary engine of growth—has now slipped into contractionary territory for the first time in eight months. Rising fuel and electricity costs are not only squeezing household disposable income but are also forcing industrial firms to scale back production as input costs soar at the fastest pace in over a year.
Philip Lane, the ECB’s Chief Economist, warned last week that the "new energy shock" resulting from the Middle East hostilities could necessitate a pivot in monetary policy. Lane, who has historically leaned toward a more dovish, data-dependent stance, noted that if higher energy costs begin to feed into broader wage demands and core inflation, the central bank may be forced to consider interest rate hikes rather than the cuts markets had anticipated earlier this year. His shift in tone reflects a growing concern within the Governing Council that inflation, which recently ticked up to 2.6%, could become unanchored.
However, the prospect of further tightening is far from a consensus view. Some analysts argue that the ECB risks overreacting to a supply-side shock that is already crushing demand. "The current downturn is fundamentally driven by an external energy spike, not an overheating domestic economy," says Antje Schiffler, an economist at Morningstar who has frequently advocated for a more cautious approach to rate hikes during periods of geopolitical instability. Schiffler suggests that raising rates into a deepening recession could exacerbate the "output gap" without effectively lowering the price of imported oil.
The divergence between the euro area’s two largest economies remains stark. In Germany, the manufacturing PMI plunged to 41.5, reflecting the country’s heavy reliance on energy-intensive heavy industry and its vulnerability to global trade disruptions. France showed slightly more resilience but still saw its services sector contract as consumer confidence waned. Across the bloc, business optimism for the next 12 months has fallen to its lowest level since the energy crisis of 2022, with firms citing the Iran war as the primary source of uncertainty.
Market pricing has shifted dramatically in response to the PMI data and recent ECB rhetoric. Traders have almost entirely priced out the possibility of a rate cut in the first half of 2026, with some derivative contracts now implying a 40% chance of a 25-basis-point hike by September. This represents a total reversal from January, when the market was betting on a series of cuts to support a fragile recovery. The euro remained under pressure following the release, as investors weighed the risks of a "hard landing" against the necessity of containing inflation.
The fiscal response across Europe also remains fragmented. While some governments have reintroduced energy subsidies to shield households, the U.S. President Trump’s administration has signaled a more protectionist trade stance that could further complicate Europe’s export-led recovery. With the Iran conflict showing no signs of immediate resolution, the euro area faces a summer of economic attrition, where the margin for policy error has narrowed to its thinnest point in years.
Explore more exclusive insights at nextfin.ai.
