For months, central bankers tried to convince themselves that inflation was dying peacefully. The post-pandemic shock was supposedly fading. Supply chains were normalising. Energy prices had stabilised temporarily. Rate hikes were beginning to slow economies. Markets started pricing future cuts almost mechanically. Then came the Middle East war. And suddenly the inflationary machine restarted. Euro-area inflation has now climbed above 3% for the first time since 2023, while core inflation accelerated more aggressively than expected. More importantly, services inflation, the category central bankers fear most because it reflects domestic pricing pressure, surged again to 3.5%. This changes the conversation entirely. Because energy shocks are dangerous not only when oil rises, but also when it starts contaminating the broader economy. And that process now appears underway.

The European Central Bank is therefore entering an exceptionally uncomfortable position. Inflation is rising again, but growth is weakening at the same time. Business activity is slowing. Manufacturing remains fragile. Consumer confidence is deteriorating. Yet policymakers increasingly believe they have no choice but to tighten monetary conditions further. Europe is slowly entering the territory central bankers fear most: stagflation. Not the catastrophic version of the 1970s, but a softer and potentially more persistent version where:

For years, Europe benefited enormously from imported disinflation: cheap global manufacturing,, abundant Russian energy, stable shipping routes, low geopolitical fragmentation, and structurally weak wage growth. Most of those pillars are now deteriorating simultaneously. Russian energy disappeared first. Globalisation fragmented second. Now, Middle East instability is attacking the third pillar: energy security itself. And Europe remains particularly vulnerable because it imports both energy and inflation. This is why the ECB’s position is arguably even more fragile than the Federal Reserve’s. The United States at least possesses domestic energy production, reserve currency status and deeper capital markets. Europe possesses none of these structural advantages. A weaker euro directly amplifies imported inflation through oil, gas, industrial inputs and transport costs.

Which means the ECB may be forced to remain more aggressive than markets currently expect. Even if the economy weakens further. This is the true trap. Raise rates too aggressively, and Europe risks recession. Move too slowly, and inflation expectations become embedded. And once wage negotiations begin, permanently adapting to higher inflation expectations makes the process far more difficult to reverse. This is precisely what worries policymakers now. Workers demand higher wages because living costs rise. Companies increase prices to preserve margins. Governments support households through fiscal spending. Deficits widen. Bond issuance increases. Financing costs rise. The inflation cycle slowly begins feeding itself.

Financial markets still appear relatively calm for now. Equities continue behaving as though central banks will eventually engineer a soft landing. But bond markets are becoming visibly more nervous. Because bond investors understand something equity investors still partially ignore: higher inflation in a highly indebted world is structurally dangerous. Especially for Europe. Several euro-area countries remain heavily dependent on low refinancing costs after years of ultra-cheap money. Higher sovereign yields progressively increase pressure on public finances, banking systems and real estate markets simultaneously.

The ECB, therefore, faces a dilemma that is no longer purely monetary. It is increasingly political. Tighter policy risks exposing fiscal fragilities inside the euro system itself. Yet tolerating higher inflation risks undermining the currency’s and the institution’s credibility. This explains the increasingly cautious tone emerging from Frankfurt. Policymakers no longer speak like central bankers approaching victory over inflation. They speak like institutions preparing for a much longer war. And perhaps this is the most important change underway globally. The old world of structurally low inflation may not be returning anytime soon. Instead, the world appears to be entering a regime shaped by geopolitical fragmentation, energy insecurity, supply-chain nationalism, higher military spending, and persistent commodity volatility. In other words, a world where inflation becomes geopolitical. And central banks were never truly designed for that kind of environment.

In such an environment, EUR/USD could remain supported even in a weak European economy, not because Europe looks strong, but because confidence in the dollar is deteriorating at the same time. The euro would no longer strengthen because Europe inspires confidence. It would strengthen because the dollar itself is progressively losing credibility at the margin. Markets are increasingly pricing in the possibility that the ECB may need to move earlier and potentially more aggressively than the Federal Reserve, given Europe’s far greater exposure to imported inflation. Interest-rate differentials, which had heavily favoured the dollar for years, may therefore begin to narrow gradually.