The European Central Bank has finally accepted what markets have been slowly discovering for months. The inflation shock is no longer an energy story. It is becoming an economic story. After raising rates for the first time since 2023, the ECB is now openly preparing markets for a second consecutive increase as soon as July. What makes this decision remarkable is not the move itself, but the timing. Europe is tightening monetary policy while growth is already slowing, business confidence is deteriorating, and the economic consequences of the Iran war continue to spread across the continent. In normal circumstances, central banks raise rates because economies are overheating. This is not a normal circumstance. Europe is facing a far more complicated challenge: stagflation. Growth is weakening while inflation is accelerating.

And policymakers increasingly fear repeating one of the most expensive mistakes in central-banking history, waiting too long. The memories of 2022 remain fresh inside the ECB. Following the Russian invasion of Ukraine, European inflation exploded while policymakers initially described the shock as temporary. The result was one of the most aggressive tightening cycles in the institution’s history. This time, Christine Lagarde and her colleagues appear determined not to be caught behind the curve again. The concern is understandable. The Iran war has pushed energy prices significantly higher. What initially appeared to be a direct oil-price shock is now spreading through transportation, logistics, manufacturing, food production and services. ECB projections now show inflation remaining above target until well into 2027, while core inflation continues moving higher.

This is precisely the scenario central bankers fear most. Not high inflation. Persistent inflation. Once inflation expectations are embedded, the problem becomes exponentially more expensive to solve. The language coming from Frankfurt has therefore changed noticeably. Joachim Nagel, traditionally one of the ECB’s more influential hawks, openly acknowledged that another rate increase may be necessary within weeks. Other Governing Council members have delivered similar messages. Even officials usually associated with a more cautious approach are increasingly discussing upside inflation risks rather than downside growth risks. The message is becoming clear. The ECB no longer sees inflation as a temporary consequence of the war. It sees a structural risk. And this is where Europe may increasingly diverge from the United States.

While the Federal Reserve remains trapped between slowing growth, political pressure and growing concerns about financial stability, the ECB appears to be moving towards a more aggressive response. Europe is considerably more vulnerable to imported inflation than the United States. It imports energy, imports commodities and remains heavily exposed to global supply-chain disruptions. The consequence is straightforward. The ECB may ultimately be forced to tighten faster and further than investors currently expect. Markets continue focusing on the Federal Reserve. They may be looking in the wrong direction. The real monetary surprise of the next twelve months could come from Europe.

The implications for the euro are potentially significant. For much of the past decade, the single currency suffered from structurally lower interest rates than the United States. That differential supported the dollar and encouraged capital flows towards American assets. If the ECB embarks on a more aggressive tightening cycle while the Federal Reserve remains constrained by slowing growth and mounting fiscal pressures, that gap could narrow rapidly. The result would be a structurally stronger euro. This is particularly important given the broader deterioration of confidence in the dollar. Rising US deficits, growing Treasury issuance, persistent inflation and questions surrounding the long-term sustainability of American public finances are already weighing on international perceptions of US assets.

A more hawkish ECB only reinforces that trend. The foreign-exchange market is beginning to understand this reality. The euro’s recent strength is no longer simply a reflection of dollar weakness. It increasingly reflects the possibility that European interest rates may need to rise above US rates for the first time in a generation. Such an outcome would have seemed unthinkable only a year ago. Today it is becoming increasingly plausible. For years, Europe was criticised for being too dependent on monetary accommodation, too reluctant to tighten policy and too vulnerable to external shocks. Now the ECB may become the first major central bank willing to confront the inflationary consequences of the new geopolitical world directly. Whether that decision ultimately succeeds remains uncertain. But one conclusion is already becoming difficult to avoid. The era of cheap money is not returning. And Europe appears increasingly willing to be the first to admit it.