Key Takeaways
- Eurozone inflation could rise above the ECB’s 2% target if energy price pressures continue due to the war in Iran.
- The European Central Bank could raise rates if the supply shock linked to energy prices spreads to wages and service costs.
- The impact of an escalation in the war could be greater because Europe has no local supplies of natural gas.
The rise in oil and natural gas prices due to the war in Iran has reignited fears that inflation in the eurozone will rise sharply again and that the European Central Bank will revise its monetary policy.
Even before the Israeli and US attack on Iran, the Consumer Price Index had surprised on the upside, rising 1.9% against expectations of 1.7%, according to Eurostat’s preliminary February estimates. This level is just below the ECB’s 2% target, but economists say it could rise above this if energy price pressures continue due to geopolitical developments in the Middle East.
Goldman Sachs has revised its growth and inflation estimates for the eurozone in light of developments in the Middle East conflict, introducing a hypothetical scenario to take into account the effects of a potential wider and more prolonged war.
In a negative scenario, Goldman Sachs economists assume that oil prices will remain at USD 80 per barrel and gas prices at EUR 70/MWh, while in the even more pessimistic scenario, they assume that oil prices will reach USD 100 per barrel and gas prices EUR 100/MWh. As a result, forecasts for overall inflation in the eurozone have been raised by 0.3 percentage points, while for core inflation, which excludes the most volatile components such as food and energy, economists predict more limited effects if the worst-case scenario does not materialize. Goldman Sachs has also lowered its economic growth estimates by 0.2 percentage points for the eurozone.
Why the Iran War Could Boost Inflation in Europe
“The outbreak of war in Iran introduces upside risks to eurozone inflation through two channels: energy prices and exchange rates,” says Martina Daga, economist at Milan-based asset manager AcomeA.
Energy prices account for about 9% of the region’s Consumer Price Index, a relatively low level when compared to food, alcohol, and tobacco, at 18.9%, and especially services, which account for 46.8%, according to Eurostat data.
For this reason, Daga is more concerned about the possible “second round” effects: the impact of higher energy costs on wages and services.
“After the shock of 2022 [Russian invasion of Ukraine], businesses and workers could react more quickly by adjusting expectations, prices, and wage demands,” she says. Daga also believes that the risk of devaluation of the euro is low for the moment.
After reaching EUR 1.15 on March 3, the euro/dollar exchange rate then returned to around EUR 1.16 when the risk of an immediate energy crisis receded from the markets.
War, Inflation, and Supply Shocks
Eurozone inflation’s starting point is low and below that of the US and UK, but the impact of an escalation could be greater because the region has no local supplies of natural gas, explains Mike Coop, chief investment officer EMEA at Morningstar Wealth.
“Historically, wars tend to be inflationary because they create supply shocks; the key questions for investors are the scale of those shocks and how long they persist,” he says.
Experts outline two scenarios:
- The best-case scenario envisages a short and localized conflict in the Middle East.
- The worst-case scenario envisages a prolonged conflict that spreads beyond the region.
In the first case, the impact on inflation in the eurozone would be limited, without compromising an overall good situation and below the ECB’s target. In the second case, however, there would be a further increase in gas and oil prices with more serious consequences for inflation.
Is the Eurozone at Risk of Stagflation?
In the worst-case scenario, the eurozone economy would face an even greater risk: stagflation, a combination of stagnation and inflation.
“The prospect of sustained higher energy pricing and deteriorating sentiment has renewed concerns around stagflation risks,” says Henry Cook, senior European economist at MUFG Bank.
“The euro economy had started the year with decent growth momentum. With some green shoots and signs of a cyclical recovery, our central scenario was for slightly-below target inflation and growth around potential. Developments in the Middle East will be a test of resilience. Stagflation risks have risen.”
In its December projections, the European Central Bank estimated inflation at 1.9% in 2026, 1.8% in 2027, and 2.0% in 2028. The central bank also estimated that a 14.2% increase in oil prices and a 20% increase in gas prices would push up the HICP inflation by 0.5 percentage points. However, this forecast doesn’t consider wider supply-chain disruption, or the prospect of a weaker euro.
Following the outbreak of war on Feb. 28, “the European interest rate market began to price in a scenario of stagflation along the [yield] curves, with the short end clearly underperforming the medium to long end,” says Massimo Spagnol, fixed income portfolio manager at Generali Asset Management. In this situation, short-term government bond yields rise faster than long-term yields.
What’s the Risk of European Recession?
The duration of the conflict is a key variable in assessing the risks of inflation and economic stagnation. Forecasting platforms such as Polymarket assign a 70% probability to a resolution by the end of April. In this scenario, Indosuez Wealth Management strategists do not see the conditions “to justify recessionary dynamics,” despite oil prices having risen by almost 20% since February.
“As a reference, estimates indicate that a sustained 10% increase in oil prices typically affects global growth by -10/-20 basis points and inflation by +20/+40 basis points,” they explain in a March 4 note.
According to Morningstar’s Coop, the outcomes will also depend on government policy response in terms of intervention if there is a lasting spike of energy prices that hits households hard. For example, they could impose a cap for home gas heating.
Will the ECB Raise or Cut Rates in 2026?
Markets expect the European Central Bank to keep its benchmark rates unchanged at 2% at its March 19 meeting, but uncertainty about the future is growing.
“At the close of trading on Tuesday, March 3, the eurozone interest rate market was pricing in a 33% probability of a 25 basis point policy rate hike in December 2026,” says Generali Asset Management’s Spagnol, who points out that the ECB may be forced to step in only in the event of “prolonged paralysis of maritime traffic” in the Strait of Hormuz, through which about 20% of global oil and liquefied natural gas consumption transits, resulting in a “structural increase in energy prices” and overall prices.
For the ECB, it is not only the direct impact of rising energy prices on the economy that is important, but also the “anchoring” of inflation expectations—the fact that the expectations of consumers, businesses, and investors remain consistent with the 2% target. A de-anchoring, with higher inflation expectations, could lead the ECB to raise rates to cool down the economy.
Goldman Sachs economists predict that the ECB will only raise interest rates in the worst-case scenario, where inflation rises by 3.6 percentage points by the end of 2026, amid a surge in oil and gas prices.
For Daga of AcomeA, the ECB’s response will depend on the nature of the shock.
“If it remains a classic supply shock linked to energy prices, the impact on monetary policy should be limited, because rates affect demand but not energy supply,” he says.
“If, on the other hand, the shock proves to be more persistent and is transmitted to core prices—through wages and services— bringing inflation back above target on a stable basis, the ECB may be forced to react.”
Oxford Economics expects the ECB to keep rates unchanged this year.
“Even in an adverse scenario, there is a case to look through the temporary inflation spike,” says Oliver Rakau, the advisory firm’s chief Germany economist.
“However, above-target core inflation, sticky inflation expectations and lessons from the inflation surge in 2022 suggest the ECB may opt for one to two rate hikes if the conflict looks likely to be protracted and the impact more severe,” he adds.
