Inflation and Interest Rate Movements in a Context of Possible De-escalation of the Conflict in Iran
By Mario Catalá
Recent developments in financial markets continue to be shaped by the prolonged impact of the conflict in Iran, which has now lasted more than 100 days. However, over the weekend, Iran and the United States announced an agreement to end the war. If confirmed next Friday with the signing of a treaty in Switzerland, this would introduce a new scenario of reduced geopolitical uncertainty, particularly through the energy channel. In this context, the U.S. economy continues to show remarkable resilience, while Europe is beginning to reflect a more evident deterioration in its macroeconomic fundamentals.
Inflation remains the primary focus of central banks, which continue to maintain a restrictive monetary policy stance, with the European Central Bank already having made an initial upward move in interest rates. All of this is taking place in an environment where market signals point to significant divergences between headline and underlying indicators, especially in the labor market and equity valuations.
United States
The U.S. economy is not currently showing clear signs of weakness despite the adverse geopolitical backdrop. Some aggregate indicators, such as GDP growth, have begun to moderate, but the labor market continues to demonstrate significant strength.
Leading indicators reflect a mixed performance. The manufacturing PMI improved to 55.1 in May from 54.5, while the services PMI remains in expansion territory at 50.7, although below expectations and the previous reading. In terms of growth, first-quarter 2026 GDP has been revised downward to 1.6% from the initial 2%, and in its latest estimate, the Atlanta Fed forecasts a reduction to 3% (from 3.8%) for the second quarter of this year, also reflecting some deceleration.
Consumer spending remains positive, although less dynamic (April retail sales grew by 0.5%, compared with 1.6% in March), while consumer confidence shows divergent signals: The Conference Board indicator stands at 93.1, above expectations, whereas the University of Michigan index has reached historic lows at 44.8.
The labor market continues to be the main pillar supporting the economy. Nonfarm payrolls increased by 172,000 jobs in May, well above the estimated 85,000, with an upward revision to the previous figure. Meanwhile, the unemployment rate remains at 4.3%, with labor force participation at 61.8%. Nevertheless, signs are beginning to emerge that may call the labor market’s strength into question, such as the decline in full-time employment. In May, the number of full-time employees fell by 79,000, bringing the total to 134 million workers, the lowest level since December 2024. This marks the second consecutive monthly decline and the fourth in the past five months. Full-time employment as a percentage of total employment has fallen to 82.4%, very close to the low recorded during the 2020 pandemic. By comparison, the peaks in 2022 and prior to the financial crisis were 83.8% and 83.2%, respectively.
Regarding inflation, May CPI stood at 4.2%, in line with expectations and four-tenths of a percentage point above the previous month (core inflation reached 2.9%). Forecasts for June point to similar levels, with CPI around 4.05% and PCE near 3.99%. In this context, the Federal Reserve remains in a somewhat more comfortable position than the ECB. While markets are no longer pricing in rate cuts, they are also not expecting rate hikes in the short term. That said, the probability of additional 25-basis-point increases by year-end has risen.
Europe
The European economy is showing more evident deterioration, mainly affected by the energy and inflation shock stemming from the conflict in Iran. May PMIs improved slightly relative to expectations but continue to provide little visibility regarding a recovery. The manufacturing PMI fell to 51.6 from 52.2, while the services PMI edged up to 47.7, remaining in contraction territory. Economic growth has undergone a significant revision, with first-quarter 2026 GDP reduced from the initial 0.8% to 0.3%, highlighting a clear slowdown.
Consumer spending is also showing some weakness, with April retail sales declining by 0.4%, although previous revisions showed slight improvement. On the confidence front, the ZEW index surprised positively at -9.1 versus the expected -21.4, possibly supported by expectations of a ceasefire.
In terms of prices, inflation continues to rise: CPI reached 3.2% in May, with core inflation at 2.5%, reflecting persistent price pressures. Against this backdrop, the European Central Bank sought to send a rapid and clear message by raising interest rates by 25 basis points at its June 11 meeting. This demonstrates that its priority remains inflation control over economic growth, despite the evident macroeconomic deterioration.
China
The Chinese economy continues to evolve steadily, with no significant changes in its main macroeconomic variables. Activity remains balanced, although without a clear capacity to accelerate, weighed down by weak domestic demand.
PMIs reflect this stability, with the manufacturing PMI standing at 50.3 in April (expansion territory), while the services PMI fell to 49.4 from 50.1, entering contraction. First-quarter 2026 economic growth stood at 1.3%, equivalent to an annualized rate of 5%, with no recent updates.
The external sector continues to be an important pillar, with exports growing 19.4% year-over-year in May (exceeding expectations), while imports increased by 27.4%. Industrial production, however, disappointed in April at 4.1%, below the estimated 6%, while the labor market remains stable with an unemployment rate of 5.2%.
As for inflation, May CPI remains contained at 1.2%, with the increase in oil prices not yet being passed on to consumers. However, at the industrial level, the Producer Price Index (PPI) has risen sharply to 3.9%, which could translate into higher final consumer prices in the coming months.