Why the ECB Is Raising Rates Into a Shrinking Economy

Europe’s economy is shrinking, prices are still rising, and the European Central Bank (ECB) is widely expected to raise interest rates anyway on Thursday.

That may sound contradictory, but that’s exactly the problem.

It’s stagflation, one of the hardest backdrops for any central bank to manage, and it’s the story sitting underneath this week’s biggest EUR event.

What’s Actually Going On With the ECB?

Start with the numbers, because they’re pulling in opposite directions.

The Euro Area economy shrank 0.2% quarter over quarter in Q1 2026, according to Eurostat’s third and final GDP estimate.

Meanwhile, Euro Area consumer price inflation rose to 3.2% year over year in May’s flash reading, up from 3.0% in April. Core inflation, which strips out volatile food and energy prices, printed at 2.5% y/y, above both the ECB’s 2% target and analyst forecasts of 2.4%.

So, growth is weakening while inflation is heating up. Not a good combo.

In a cleaner economy, slowing growth would usually cool inflation. This isn’t a cleaner economy.

The ECB’s own Survey of Professional Forecasters upgraded 2026 Euro Area inflation expectations to 2.7% from 1.8%, while cutting the GDP growth forecast to 1.0%.

Germany’s Services PMI, a gauge of business activity where anything below 50 signals contraction, came in at 48.1 for May. Germany is the Euro Area’s largest economy, so weakness there isn’t some tiny footnote hiding in the back of the report.

Why Is Europe Dealing With Both Inflation and Slow Growth?

A big part of the problem traces back to February 28, when Israel and U.S. strikes on Iran led Tehran to partially close the Strait of Hormuz, a key waterway for global oil flows.

Energy prices spiked, and Europe felt it quickly. The region imports a large share of its energy needs, so oil shocks hit households and businesses almost immediately. Higher fuel costs feed into transportation, manufacturing, heating, and eventually the prices of many everyday goods and services.

The problem is that this no longer looks like a simple energy story. May’s core inflation reading came in above forecast, which suggests higher energy costs may be bleeding into broader prices. That’s the signal the ECB can’t easily ignore.

At the same time, the oil shock is weighing on growth. When businesses and consumers spend more on energy, they’ve got less to spend elsewhere. That’s how inflation pressure and weak growth can show up at the same time.

This is why stagflation is such a headache. A central bank has one main lever: interest rates. Raise rates, and borrowing costs rise, spending slows, and inflation may cool. But if the economy is already slowing, higher rates add more pressure. Cut rates to support growth, and inflation can get worse. Let inflation run too long, and it can become embedded in wages, prices, and expectations.

There’s no clean answer, and that’s the ECB’s problem in June.

What Does the ECB’s Move Mean for EUR?

Thursday’s expected 25 basis point hike would lift the deposit facility rate from 2.00% to 2.25%, while the main refinancing operations rate would move from 2.15% to 2.40%.

But the hike itself may not be the real market mover. Rate futures markets have already priced the move above 90%, which means traders have had time to prepare for it. The bigger driver may be ECB President Christine Lagarde’s press conference at 12:45 GMT. More specifically, how much guidance she gives on what could come next.

See, central bankers don’t always speak plainly. They speak in carefully chosen phrases, and markets tend to read those phrases closely.

If Lagarde leans on “data dependent” or “meeting by meeting” language, that would signal limited conviction about the next move. In market terms, it means the ECB may be delivering one hike without clearly committing to a tightening cycle. That could make it harder for EUR to hold any initial gains.

If she describes inflation risks as “asymmetric” or skewed to the upside, the message would be more hawkish. Traders may read that as a signal that more hikes are possible later this year, especially in the autumn. That could support EUR by narrowing the policy gap with a Fed currently in its pre-FOMC blackout period.

Internal unity also matters. If Lagarde says the decision was unanimous, it would suggest conviction and could support the euro.

If she hints at division, markets may take that as a sign that the hiking cycle is already close to its limit.

That’d be a very different story for EUR.

One More Thing Before You Open a Chart

There’s also a trading structure issue to keep in mind before Thursday’s 12:15 GMT announcement.

Ahead of major central bank events, institutional market makers often pull limit orders from the market. They don’t want to be caught with large exposure on the wrong side of a surprise. That drains liquidity right when volatility usually jumps, which means even modest trading volume can move EUR/USD sharply in seconds.

This is why the first candle after the announcement can be misleading. A violent spike in one direction can reverse quickly once liquidity returns. The more meaningful move often develops during Lagarde’s press conference, when traders have more language to price and more time to judge what the ECB may do next.

For newer traders, this is a useful lesson on event risk. The headline move isn’t always the real move.

Key Takeaways

Stagflation combines rising inflation with a stagnating or contracting economy. It’s one of the toughest environments for a central bank because the usual policy tools work against each other.
The ECB appears to be prioritizing inflation control over near-term growth support. The logic is that entrenched inflation expectations can be more painful and expensive to unwind later.
With Thursday’s 25bps hike already priced in above 90%, Lagarde’s press conference may matter more for EUR than the rate decision itself.
Three language cues are worth watching: “data dependent” suggests no firm commitment, “asymmetric upside risks” points to more hikes, and unanimity signals conviction. Any hint of division could suggest the cycle is nearing its limit.
The first 15 to 30 minutes after the statement can be noisy because liquidity is often thin. The more sustainable direction may not show up until the press conference is underway.

Watch Out For

The ECB rate decision is due Thursday, June 11, at 12:15 GMT. Lagarde’s press conference begins at 12:45 GMT. EUR/USD, EUR/JPY, and EUR/GBP are the main pairs to watch for post decision movement.

China CPI and PPI at 1:30 AM GMT Thursday may also help shape the overnight tone for commodity and risk-sensitive currencies heading into the ECB session.

If reading the ECB’s press conference language and what different phrases signal about the policy path ahead is unfamiliar territory, Premium members can read our lesson:

📖 Hawkish vs. Dovish: How to Read Central Bank Language

Reading this helps you understand hawkish and dovish language signals, how to identify where a central bank sits on the policy spectrum, and why a single press conference can move a currency more than the rate decision itself.

And if you’re not a Premium subscriber yet, now might be a good time to sign up.

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