Brussels: Concerns over stagflation in the eurozone are intensifying as inflationary pressures linked to the Middle East conflict coincide with a weakening growth outlook. The closure of the Strait of Hormuz has disrupted supply chains and pushed oil prices higher, fueling inflationary pressures across the global economy and raising risks to growth.

According to Anadolu Agency, Europe's economic outlook has shifted significantly from earlier expectations that the US-Israel-Iran conflict would be short-lived and that economic growth would outpace inflation. Instead, prolonged hostilities and concerns that the conflict could last longer than anticipated have heightened stagflation fears, particularly in the eurozone, where rising energy costs are adding to inflationary pressures.

The eurozone's inflation rate rose to 3.2% in May, well above the European Central Bank's 2% target. At the same time, the region's economy contracted 0.1% in the first quarter compared with the previous quarter. Retail sales in the bloc fell 0.4% month-on-month in April, while the impact of the conflict has been particularly visible in Germany.

Germany's industrial production declined 0.5% year-on-year in April, while factory orders fell 3.8% month-on-month despite rising 1.6% annually. The German economy is expected to contract in the second quarter as it grapples with these challenges alongside ongoing difficulties in the automotive sector. Germany's retail sales also fell 0.3% month-on-month and 2.7% year-on-year in April.

Meanwhile, the ECB is widely expected to raise interest rates on Thursday, while expectations for rate cuts have been pushed back from March 2027 to mid-2027. The ECB's new economic projects are expected to include downward revisions to growth and inflation. The ECB's updated economic projections are expected to include downward revisions to growth forecasts and upward revisions to inflation expectations.

Analysts warn that an interest rate increase could prove premature given already weak economic activity across the bloc. Kutay Gozgor, investment research director at Turkish lender Kuveyt Turk, told Anadolu that the eurozone's first-quarter contraction and the loss of momentum in German industry point to weakening growth dynamics. Gozgor said inflation, which rose to 3% in April and accelerated further to 3.2% in preliminary May data, reflects a classic supply-shock scenario, while the European Commission's downward revision of growth forecasts indicates that policymakers recognize the structural slowdown.

'It's still too early to declare full-blown stagflation from the perspective of macroeconomic balances,' he said. 'The resilience of the region's labor market and the absence of a massive deterioration in unemployment are key factors shielding the economy from the worst-case scenario.'

'The current situation can be seen as a temporary rebalancing triggered by external shocks and not a permanent economic collapse, although risks remain,' he added. Gozgor said it would be more accurate to view the current environment as a strong warning signal rather than the direct onset of stagflation, noting that the combination of weak growth and declining industrial production creates conditions that could lead to such a scenario.

'Whether this situation becomes permanent depends on the deepening of the energy crisis and firms reducing their production capacities in the long term,' he said, adding that policymakers still have fiscal and trade-policy tools available to ease the pressure. 'Despite weakening consumer confidence, the vitality in certain service sectors offers buffers preventing the early signs of stagflation from turning into a structural crisis. While the regional economy is feeling the pressure, it's not too late to get out of this spiral,' he added.

Gozgor also said the ECB faces a difficult monetary policy dilemma as inflation continues to move away from its 2% medium-term target while economic activity remains weak. 'Current market pricing and futures have increased expectations that the bank may implement further rate hikes to prevent inflation expectations from deteriorating further, while inflation continuing to rise in May makes it impossible for the bank to adopt a dovish stance despite the economic slowdown,' he said. 'We may see a hawkish stance prioritizing price stability at the expense of growth, maintaining the option of rate hikes while continuing tightening measures for the rest of the year,' he added.