Iran war drags European economy down, pushes prices up

* Euro zone composite PMI lowest since October 2023

* European Commission downgrades forecasts

* War impacts add to domestic worries in UK

By Jonathan Cable and Mark John

LONDON, May 21 (Reuters) - The energy shock from the Iran war is seeping ever deeper into the European economy, presenting policy-makers with a dilemma as it simultaneously weighs on growth and pushes prices higher, a broad set of data on Thursday showed.

While most economists say this still cannot be compared to the outright "stagflation" mix of high inflation and stagnant growth that accompanied the energy shocks of the 1970s, it will exacerbate the cost of living crisis that followed the COVID-19 pandemic and which millions of households are still facing.

That in turn is complicating central bank decisions about interest rate moves and what kind of support the region's governments offer to consumers facing higher fuel costs.

Activity in the euro zone shrank at its sharpest rate in over two-and-a-half years in May as a surge in living costs hammered demand in the dominant services sector and pushed input price inflation to its highest in three-and-a-half years, a closely followed S&P Global survey showed on Thursday. Separately, the European Commission downgraded its growth projections for the euro zone economy and acknowledged they could fall further if the disruption meant that energy prices only reached their peak by the end of this year. Outside the euro area, companies in Britain suffered their broadest drop in activity in over a year as the economic impact of the Iran war combined with political uncertainty at home.

S&P Global's Flash Euro Zone Composite Purchasing Managers' Index fell to 47.5 in May from 48.8 - its lowest since October 2023 - and below a Reuters poll forecast which predicted no change from April. The reading marked the second consecutive month of contraction across the bloc's private sector.

A PMI below 50.0 indicates slowing activity.

"This is the weakest level since late 2023 and, at face value, signals that the economy has been stagnating in May," JP Morgan analysts said in a note.

JUNE ECB RATE HIKE LIKELY - BUT THEN WHAT? Private sector activity in Germany, Europe's largest economy, contracted for a second consecutive month in May while in France the headline PMI fell to its lowest in five-and-a-half years with firms citing fuel and energy cost pressures, as well as general economic angst, as reasons for lower output. In a separate release, the Bundesbank said inflation in Germany was trending upwards and economic growth will likely be flat during the second quarter.

Overall demand in the euro zone deteriorated sharply. New orders across the private sector fell at their fastest pace in 18 months, with new export orders declining at the steepest rate since January 2025. Services new business dropped sharply, while factory demand, which rose in April, swung back into decline.

Services activity - the dominant driver of the euro zone economy and a key gauge of consumer demand - contracted at the sharpest pace since February 2021, falling to 46.4 from 47.6 in April, against a poll finding for a modest uptick to 47.7.

The overall manufacturing PMI fell, as did the reading for output, which feeds into the headline figure.

Moreover, those numbers were likely falsely elevated by supply issues lengthening delivery times of factory goods to their worst since COVID-19.

At the same time, cost pressures intensified sharply. Input price inflation accelerated to a three-and-a-half year high, the composite PMI showed. Prices charged to customers also rose at their fastest pace in 38 months, though only marginally faster than in April. S&P Global warned the price gauges point to inflation running close to 4% in coming months.

The labour market deteriorated further. Euro zone companies cut headcount for a fifth consecutive month, with the pace of job losses the steepest since November 2020 - and, excluding the pandemic, the largest since August 2013. Services firms reduced headcount for the first time since early 2021, while manufacturing payrolls shrank again. The European Central Bank left interest rates unchanged late last month but is widely seen hiking in June. But the question now is whether the weakness in the economy persuades it to pause again after that.

"There is nothing here to put the ECB Governing Council off its plans to raise rates by 25 basis points in June, nor anything to ease concerns about the risks of a recession," said Andrew Kenningham at Capital Economics.

Inflation in the common currency area held at 3.0% in April, official data showed on Wednesday, above the ECB's 2.0% target.

The European Commission said on Thursday it now forecasts euro zone output growth will slow to 0.9% in 2026 from 1.3% in 2025, with a rise of 1.2% in 2027. In its last set of forecasts in November, the expectations were respectively 1.2% and 1.4%.

But European Economy Commissioner Valdis Dombrovskis said that under a more adverse scenario of energy prices not peaking till late 2026, those forecasts would roughly halve. (Reporting by Jonathan Cable; Editing by Toby Chopra)