Inflation: Back to the future

Consumer price data recorded the sharpest acceleration in three years in both April and May in the United States¹, driven by the rebound in commodity prices observed since the beginning of the year. This development is more concerning given that core inflation, as measured by the PCE index, has remained above the Fed's 2% target for 63 consecutive months, with little tangible evidence suggesting a swift return to target.

Several imbalances lie behind these persistent inflationary pressures.

• Firstly, the U.S. economy continues to benefit from exceptionally strong fiscal support. The various stimulus packages implemented under the Biden administration - notably the Inflation Reduction Act and the CHIPS Act - and subsequently reinforced by programs announced under Donald Trump, such as Stargate and the One Big Beautiful Bill Act, have sustained robust economic growth while supporting household purchasing power – albeit with some divergence in income categories. The highest income households and pensioners have also continued to benefit from significant wealth effects, fuelled by the strong performance of equity markets over recent years.

• Secondly, the tariffs announced on "Liberation Day" on April 2, 2025, have begun to feed through to consumer prices. To date, they are estimated to have contributed nearly 0.8² percentage points to core PCE inflation. Such tariffs may be considered as transitory by most, yet this pass-through is expected to continue over the coming quarters, as companies have so far largely absorbed the shock through inventories accumulated before the implementation of the new tariff measures.

• Finally, the immigration reforms introduced at the beginning of 2025, together with the intensification of deportations, have now resulted in negative net migration flows. This contraction in labour supply is expected to gradually exacerbate labour market tightness and reinforce wage pressures, with unemployment at 10 months lows and annual wage growth already standing at 3.4%³.

Against this backdrop, the Trump administration's military intervention in the Middle East has added further fuel to an inflationary dynamic that has already been building for several months. Admittedly, with the midterm elections approaching, the U.S. administration remains particularly sensitive to developments in gasoline prices, a highly visible variable for American consumers. The announcement of the gradual release of 172 million barrels from the Strategic Petroleum Reserve provides temporary relief at the pump and helps contain the immediate impact of the energy shock. Going forward, should geopolitical tensions persist, sustained high energy prices would likely lead to a broader transmission of inflationary pressures throughout the U.S. economy.

Conversely should some form of “deal” be agreed upon, strategic reserves will have to be reconstituted fuelling demand for the quarters ahead. Besides the blockade also means that gold is not the only reserve asset anymore. Commodities have re-entered the strategic playbook of governments worldwide. Such risks appear even more significant given that inflation transmission mechanisms were already well underway before the recent surge in oil prices.

Moreover, the Fed’s independence could come under increasing pressure in the years ahead. The new Federal Reserve Chair is operating in a political environment where expectations for a more accommodative monetary policy are likely to remain elevated, and where the boundaries between monetary and fiscal policy are increasingly being challenged, if not redefined. Beyond the fight against inflation, pressure could mount to maintain favourable financial conditions in order to finance investments related to artificial intelligence and growing fiscal deficits, support asset markets and, more broadly, preserve economic momentum.

In such an environment, the risk is that inflation becomes entrenched above the Fed's target, forcing policymakers to navigate an increasingly difficult trade-off between price stability, support for economic activity and financial stability.

Much like Schrödinger's cat, the nature of inflation in Europe remains difficult to determine with certainty. While inflation appeared to have been decisively subdued just six months ago, members of the ECB now seem increasingly concerned that the current energy shock could reignite the inflationary dynamics experienced three years ago. Such concerns are justified, as the euro area remains highly vulnerable to geopolitical events capable of disrupting global supply chains. The supply-chain dislocations triggered by the Covid-19 pandemic, combined with the commodity price shock following Russia's invasion of Ukraine in 2022, had already left lasting scars on the European economy. Against this backdrop, the escalation of tensions between the United States and Iran represents a new source of uncertainty, the temporary nature of the shock remains far from assured. Indeed, the succession of inflationary shocks in recent years may have made economic agents more sensitive to rising prices, increasing the risk that inflation expectations become more persistent and eventually de-anchor.

Inflation in the euro area has already reached 3.2% as of end of may⁴, its highest level since September 2023. Price pressures also appear to be spreading to core inflation, whose increase in May exceeded market expectations. Although underlying inflationary pressures remain significantly less concerning than in the United States, the ECB has limited room to contain potential second-round effects, particularly through a wage-price spiral, at a time when annual wage growth still stands at 3.0%⁵.

In a late-cycle European economy, the region's already modest growth outlook is likely to be further undermined by the Middle East conflict, with GDP growth expected to slow to just 0.8% this year. This weakness in economic activity will constrain the ECB's ability to maintain a restrictive monetary policy for an extended period. At the same time, governments have limited fiscal leeway to compensate for tighter monetary conditions, whether to support household purchasing power or sustain economic growth. Public deficits remain above the thresholds established by the Maastricht Treaty, while political instability across several major European economies continues to hinder the implementation of meaningful structural reforms.

Against this backdrop, the spectre of stagflation is gradually re-emerging. Such an environment would be considerably more problematic—and potentially more persistent—than the inflationary episode of 2022–2023. Despite these challenging prospects, financial markets continue to anticipate a relatively rapid normalization of inflation. The two-year inflation breakeven currently stands at 2.6%, significantly below the 3.4% peak reached in mid-March. Five-year and ten-year inflation expectations are both trading at 2.2%⁶, only 20 basis points above the levels observed before the conflict. While a rapid normalization scenario remains plausible, markets still appear to assign only a limited probability to a less favourable outcome. At this stage, the risk of a more persistent inflation regime does not seem to be fully reflected in asset valuations.

As geopolitical tensions continue to deepen in the Middle East, each additional day without a normalization of trade flows adds further pressure to the inflation outlook for the months ahead. Most forecasting models currently rely on energy price curves that mechanically incorporate a favourable backwardation structure, implying a gradual decline in energy prices over time. However, this assumption may prove overly optimistic should the current disruptions persist. Likewise, should the Strat of Hormuz reopen, the threat of renewed closure, of a toll being levied or growing insurance costs to adapt to new potential disruptions will keep prices higher than before the war.

In addition, base effects are likely to contribute to a mechanical reacceleration of inflation over the coming quarters. The sharp decline in commodity prices recorded during the second half of 2025, amid misplaced concerns over a slowdown in the U.S. economy, now provides a particularly “favourable” comparison base. As these effects gradually roll out of year-on-year calculations, inflation indicators are likely to display less favourable dynamics. These technical factors, combined with persistent investor optimism, help explain why U.S. inflation breakevens continue to trade more than one percentage point below the core PCE inflation rate recorded at the end of June (3.7%)⁷.

Such a divergence nevertheless appears difficult to justify, given that the transmission of the energy shock to the broader economy is still far from complete and that the duration of disruptions affecting the Strait of Hormuz remains one of the key uncertainties in the current macroeconomic outlook. Adding to this are the pressures affecting other agricultural commodities, which are facing particularly adverse weather conditions this year, notably linked to the “Super El Niño” phenomenon, as well as disruptions to fertilizer supplies originating in part from the Middle East.

Unlike the 2022 energy shock, which resulted from sanctions imposed on Russia, trade flows originating from the Middle East - particularly oil & gas - offer limited substitution possibilities in the short term. A significant share of global energy supply transits through this strategically important region and cannot easily be rerouted or rapidly replaced by alternative production capacity, the development of which may take years to materialize, whether through the opening of new energy fields or the expansion of renewable energy infrastructure. After several months of tensions and in the absence of tangible signs of improvement, the most prudent scenario is now to assume a prolonged disruption of energy supplies.

Such a development would likely translate into progressively higher production costs, initially affecting the most energy-intensive industries before gradually spreading across the broader economy through successive price increases.

The principal risk now lies in a gradual de-anchoring of inflation expectations. Such a development would occur at a time when major central banks have limited room to respond effectively to a renewed supply-side shock. With economic growth already weakening and inflation still above target, monetary authorities could find themselves facing particularly difficult trade-offs in the quarters ahead, forced once again to balance price stability against support for economic activity.