The air smells of stagflation, and central banks have no good moves.
Three months into a Middle East energy crisis, the world's economies find themselves caught in an old and painful bind: prices rising while growth falters, a condition that has historically humbled even the most confident policymakers. From European factory floors to Australian service counters, May's purchasing manager surveys tell a story of mounting strain — companies absorbing costs they cannot sustain, central banks weighing remedies that may worsen the illness. The outcome, as so often in human affairs, hinges on a conflict no economist can resolve.
- Manufacturing activity contracted across nearly every major economy in May, with France and Germany sliding deepest into negative territory as energy costs from the Middle East crisis drove input prices to multi-year highs.
- Australia's business confidence collapsed to its lowest point since the pandemic, while the United States saw a paradoxical surge in factory output driven by panic-buying ahead of anticipated price increases — masking rather than resolving the underlying fragility.
- Central banks now face a stagflation trap: eurozone inflation is tracking toward 4%, yet raising interest rates to contain it risks tipping already-weakened economies into outright recession.
- Bond markets have already moved — long-term government yields have climbed to their highest levels in over two decades, signaling that investors believe aggressive rate hikes are coming regardless of the growth cost.
- The entire trajectory of the global economy now pivots on a single geopolitical variable: how long the Middle East conflict persists and whether disruptions to the Strait of Hormuz deepen into a full supply shock.
Three months into an energy crisis born of Middle East conflict, the world's factories and service providers are delivering a consistent and uncomfortable message: growth is decelerating while prices keep climbing. May's purchasing manager surveys, spanning Australia to Europe, painted a portrait of mounting strain. Manufacturing contracted or stalled across nearly every major economy — the United Kingdom was the lone exception — while service sectors showed their own signs of exhaustion.
The eurozone bore the sharpest damage. France's manufacturing indicators fell harder than expected, and both France and Germany slipped into contraction. Broader regional activity shrank at its fastest pace in two and a half years, sustained only by manufacturers rushing to build inventory before prices climb further. Australia fared even worse: its factory index barely registered expansion, services contracted sharply, and business confidence hit its lowest point since the pandemic's darkest days. The United States told a different story — manufacturers reported their fastest expansion in four years — but raw material costs hit their highest level since mid-2022, and employment in both sectors fell at rates unseen in nearly two years. India and Japan offered rare resilience, though neither was immune to rising energy costs.
For central bankers, the convergence of weak growth and rising inflation has created a genuine nightmare. Economists at Royal London Asset Management described the mood plainly: Europe faces a clear recession risk, and the air smells of stagflation. Price indicators now point to eurozone inflation near 4% in coming months, pushing the European Central Bank toward rate increases even as higher borrowing costs threaten to tip fragile economies over the edge. Belgium's central bank governor told Bloomberg Television that a June rate hike is 'likely' if the war doesn't end soon. Bond markets have already responded — long-term government yields have climbed to their highest levels in more than two decades.
What comes next depends almost entirely on the Middle East. If the conflict and the blockade of the Strait of Hormuz persist, oil shortages could spread across multiple sectors and trigger a substantial blow to demand itself. That uncertainty is what keeps policymakers awake: they must choose between letting inflation take hold or raising rates and risking the very recession they are trying to prevent.
Three months into an energy crisis born of Middle East conflict, the world's factories and service providers are sending the same message: growth is slowing while prices keep climbing. Surveys of purchasing managers from Australia to Europe in May painted a picture of mounting strain. Manufacturing activity, tracked by S&P Global, contracted or stalled across nearly every major economy measured on Thursday—the United Kingdom was the lone exception—while service sectors showed their own signs of fatigue.
The pressure is real and visible in the numbers. Companies are caught between two bad choices: absorb the soaring costs themselves or pass them along to customers. In the eurozone, the damage was sharpest. France's manufacturing indicators fell harder than expected, and both France and Germany have now slipped into contraction. The broader picture across the region showed activity shrinking at its fastest pace in two and a half years, propped up only by manufacturers still rushing to build inventory before prices climb further.
Australia experienced even steeper weakness. Its factory index barely registered expansion, services contracted sharply, and a measure of business confidence hit its lowest point since the pandemic's darkest days—though this time the worry was inflation, not lockdowns. In the United States, the story was different: manufacturers reported their fastest expansion in four years, driven by customers scrambling to stock up ahead of price increases. Yet the cost of raw materials hit its highest level since mid-2022, and employment in both manufacturing and services fell at rates not seen in nearly two years.
India and Japan showed more resilience. Their manufacturing sectors maintained relatively robust expansion, though slower than before. Japan's inventory buildup appeared to be helping, but energy costs were still being felt. India's economy kept moving forward, a rare bright spot in a darkening global picture.
This convergence of weak growth and rising inflation has created a nightmare scenario for central bankers. Melanie Baker, an economist at Royal London Asset Management, described the mood plainly: there is a clear risk of technical recession in Europe, and the air smells of stagflation. Annabel Fiddes of S&P Global Market Intelligence warned that if cost pressures keep climbing while demand softens, business confidence and the broader economy could face serious strain. Chris Williamson, S&P Global's chief economist, summed up the data as "only modest growth in business activity, as demand was again pressured by a fresh surge in prices and jobs were cut."
The dilemma facing policymakers is acute. Inflation measures in the surveys are rising sharply—Williamson noted that price indicators now point to eurozone inflation near 4 percent in coming months. That reality is pushing the European Central Bank toward rate increases, even though higher borrowing costs could tip fragile economies into recession. Pierre Wunsch, Belgium's central bank governor, told Bloomberg Television that a rate hike on June 11 is "likely" if the war doesn't end soon. The bond market has already reacted: long-term government yields have climbed to their highest levels in more than two decades as investors price in both inflation and the prospect of aggressive rate hikes.
The United Kingdom's overall activity index fell for the first time in more than a year, weighed down by internal political turbulence alongside the global energy shock. Manufacturing there continued to grow, but that momentum will likely fade once customers finish restocking before prices rise further. In Britain, as elsewhere, the inventory surge is masking underlying weakness.
What happens next depends almost entirely on the Middle East. If the conflict and the blockade of the Strait of Hormuz persist, the question becomes whether oil shortages will spread across multiple sectors and trigger a substantial blow to demand itself. That uncertainty is what keeps central bankers awake: they must choose between letting inflation take hold or raising rates and risking the recession they're trying to prevent.
Notable Quotes
Given weak growth in Europe, there is a high probability we enter technical recession. Right now there is clearly a whiff of stagflation in the air.— Melanie Baker, economist, Royal London Asset Management
If cost pressures keep rising and demand softens, business confidence and the broader economy could face greater strain.— Annabel Fiddes, economist, S&P Global Market Intelligence
The Hearth Conversation Another angle on the story
Why does manufacturing contraction matter so much if companies are still building inventory?
Because inventory builds are a temporary prop. Companies are buying now to beat price increases, not because demand is actually strong. Once they've stocked up, that demand evaporates—and then you see the real weakness underneath.
So the eurozone is in worse shape than the U.S.?
Much worse. The U.S. has this inventory surge masking the damage. Europe doesn't have that cushion. France and Germany are already contracting, and the whole zone is shrinking faster than it has in years.
What's the central bank trap here?
They need to raise rates to stop inflation from taking root, but raising rates kills growth. In Europe especially, growth is already fragile. Hike rates too much and you tip into recession. Don't hike enough and inflation becomes embedded in wage expectations and pricing.
Is this actually stagflation?
It's starting to look like it. You have inflation pressures near 4 percent while growth weakens. That's the definition. The last time we saw this was the 1970s, and it was brutal to manage.
What would make this worse?
If the Middle East conflict drags on and oil supplies actually get disrupted—not just prices spike, but actual shortages. Then you're not just dealing with inflation and weak growth. You're dealing with demand destruction on top of it.
Which economies are actually holding up?
India and Japan are doing better than most. But even they're feeling the energy cost pressure. There's nowhere to hide from this.