ECB faces warnings of recession risk if it raises rates in June

The European Central Bank is steering toward a June rate increase that several senior economists say could convert the euro area's current stagflation into an outright recession. With inflation at 3% in April, the highest reading since September 2023, markets have priced an 86% probability of a 25 basis point hike at the governing council's next meeting on June 11. Yet the very data the ECB cites to justify tightening also shows demand and employment weakening across the bloc's three largest economies.

Energy-driven stagflation in the big three

Germany, France and Italy have absorbed a sharp rise in energy costs over the past year, a shock that has lifted prices while simultaneously draining household purchasing power. Holger Schmieding, chief economist at Berenberg, describes the result as a stagflationary environment: inflation above target alongside stagnant or contracting output. The distinction matters because the policy response to demand-driven inflation, raising rates to cool spending, is the opposite of what a supply shock requires.

Schmieding argues that the inflation component of stagflation is already correcting itself. As consumers divert income to cover energy bills, discretionary spending falls, creating the demand destruction that normally follows monetary tightening, but without the central bank having to act. "It's important to distinguish between what the central banks unfortunately are likely to do and what would be the right thing," he told CNBC's Europe Early Edition on Friday. "My impression is that the European Central bank is going to make a big mistake."

What the latest data actually show

The ECB's own governing council acknowledged at its April 30 meeting that "the upside risks to inflation and the downside risks to growth have intensified." That statement accompanied a decision to leave the deposit facility rate at 2%. Since then, the flash estimate for April inflation came in at 3%, up from 2.4% in March, driven largely by energy and food. Core inflation, which strips out those volatile components, has been more stubborn but shows signs of peaking.

Purchasing managers' index surveys released in May point to weakening employment intentions and new orders across manufacturing and services. In Germany, the composite PMI slipped below the 50 threshold that separates expansion from contraction. France and Italy have shown similar softening. These are not yet recessionary readings, but they indicate that the transmission of previous rate increases, the ECB has raised the deposit rate by 450 basis points since July 2022, is still working through the economy.

The case against a June hike

Schmieding's argument rests on the lagged effect of monetary policy. The full impact of the tightening cycle that ended only months ago has not yet been felt in credit markets, investment decisions or labour demand. Adding another increase now, he says, risks over-tightening. "If the European Central Bank hikes rates in June, which it seems hell-bent to do, that would add to the economic misery. If the ECB then follows up with further rate hikes, we would probably end up in a mild recession rather than just stagflation."

The mechanism is straightforward: higher borrowing costs raise the hurdle rate for business investment, increase debt service for households with variable-rate mortgages, a significant share in several euro-area countries, and tighten bank lending standards. The ECB's own bank lending survey for the first quarter showed a further net tightening of credit standards for loans to enterprises, the seventh consecutive quarter of tightening.

Why the ECB may move anyway

The governing council's inflation mandate is symmetric but politically asymmetric: missing on the high side carries more reputational risk than missing on the low side. After years of undershooting the 2% target, the ECB is determined not to be seen as complacent. The 3% headline figure, even if energy-driven, complicates the communication of a pause. Several governors have signalled in recent speeches that they want to see core inflation clearly on a downward path before declaring victory.

Market pricing reflects this hawkish bias. BBH's note placing an 86% probability on a June hike suggests traders expect the ECB to follow a playbook similar to the Federal Reserve's 2022-23 cycle: keep tightening until something breaks, then cut aggressively. The euro has strengthened modestly against the dollar since April, partly on rate differential expectations, which in turn dampens imported inflation, a feedback loop the ECB watches closely.

Insurance hikes and the risk of overtightening

Laura Cooper, global investment strategist and head of macro credit at Nuveen, offers a slightly different framing. She expects the ECB to embark on what she calls "insurance" hikes over the summer, small increases justified not by current inflation but by the risk that projections prove too optimistic. "The greater risk is that policymakers respond to supply-driven inflation persistence by tightening into weakening demand conditions, creating the setup for deeper easing further down the line," she wrote in a note to clients.

Cooper's warning echoes a pattern seen in previous cycles. The ECB raised rates in 2008 and 2011 despite mounting growth risks, only to reverse course within months as the financial crisis and then the sovereign debt crisis deepened. The institutional memory of those episodes should argue for caution, but the current leadership has emphasised that inflation credibility, once lost, takes years to rebuild.

Divergence within the euro area

A single rate for 20 economies always creates winners and losers. Germany's industrial sector, energy-intensive and export-oriented, is more exposed to both high energy costs and higher borrowing costs than the services-dominated economies of southern Europe. France sits somewhere in between, with a larger public sector buffer but rising debt servicing costs. Italy, with a debt-to-GDP ratio above 140%, is acutely sensitive to the spread between its sovereign yields and Germany's, a spread that widens when markets expect ECB tightening.

The ECB's transmission protection instrument (TPI), designed to cap fragmentation risk, has never been tested. Its activation criteria include compliance with EU fiscal rules, a condition that several member states currently stretch. If a June hike triggers a sell-off in Italian bonds, the governing council would face an immediate test of whether the TPI is credible or merely a theoretical backstop.

What the June meeting will decide

The June 11 decision will be accompanied by updated staff macroeconomic projections, the first since March. Those forecasts will incorporate the April inflation surprise, the latest PMI data, and the impact of recent oil price movements. If the projections show inflation returning to 2% by late 2025 without further hikes, the doves on the council, likely including governors from France, Spain and Italy, will argue for a pause. If the projections show persistence above target into 2026, the hawks, traditionally led by Germany, the Netherlands and Austria, will push for at least one more increase.