ECB sees inflation risks, AI fuels market optimism

Persistent inflation risks from the Middle East conflict contrasted with robust investor optimism driven by the artificial intelligence boom.

Inflation fixings for 2026 remained above 3 percent and above 2 percent for 2027, with market-based options assigning a 45 percent probability to inflation exceeding 2.5 percent over the next two years.

Brent crude oil prices fell from USD 118 to USD 94 per barrel, but longer-term futures and gas prices (50 percent above pre-war levels) remained elevated, with refined products seeing 40-45 percent price increases.

Markets firmly priced in a 25 basis point ECB rate hike in June, a second in September, and an 84 percent probability of a third by end-2026.

AI-driven optimism supported risk sentiment, leading to recovered euro area equity markets and narrow corporate and sovereign bond spreads.

Financial conditions were broadly unchanged since April but remained tighter than before the Middle East conflict.

Euro area headline inflation (HICP) increased to 3.2 percent in May, with core inflation rising to 2.5 percent.

Services inflation remained elevated at 3.5 percent.

Domestic cost pressures eased in Q1 2026, as the GDP deflator declined to 2.3 percent and negotiated wage growth slowed to 2.5 percent.

The June staff projections now foresee headline inflation averaging 3.0 percent in 2026, 2.3 percent in 2027, and 2.0 percent in 2028.

These projections reflect an upward revision of 0.4 percentage points for 2026 and 0.3 percentage points for 2027, mainly due to higher energy and food price assumptions and stronger indirect effects from the energy shock.

Core inflation is projected at 2.5 percent for both 2026 and 2027, and 2.2 percent for 2028, with all core projections also revised upwards.