A senior official at the European Central Bank (ECB) stated that the central bank might need to adjust its policy interest rates if the energy shock resulting from the Iran and Middle East conflict escalates further. This warning highlights the risk of a second major energy shock in four years potentially driving inflation above the ECB's 2% target.
Following a period of hard-won price stability and robust growth, the eurozone economy is facing another severe test. Inflation had previously returned to target levels, real incomes had recovered from the last energy shock, and domestic demand within the eurozone had partially offset the drag from US tariff hikes and a surge in imports from a major Asian economy. However, disruptions to energy flows due to the Middle East conflict, including the closure of the Strait of Hormuz, are beginning to significantly impact global supply chains.
Inflation has picked up while economic growth has slowed. The eurozone's overall inflation rate rose to 3% in April, primarily driven by a 10.9% increase in energy prices, while the core inflation rate, excluding energy, fell to 2.2%. The eurozone's GDP grew by only 0.1% quarter-on-quarter in the first quarter, falling short of the ECB's expectations.
The official indicated that the short-term shock to global oil supply from this conflict exceeds the combined impact of the three energy crises in 1973, 1979, and 2022. Even after accounting for rerouting and releases from strategic reserves, the net reduction in supply is estimated at approximately 12 million barrels per day, equivalent to about 11% of pre-conflict global supply. Restoring production will take time due to damage to key oil facilities. Natural gas prices have increased, but the rise is significantly less than the surge seen following the 2022 Russia-Ukraine conflict.
The closure of the Strait of Hormuz has also affected trade in liquefied natural gas, refined oil products, aluminum, helium, sulfur, and fertilizers. Delivery times have lengthened and input costs have risen, although the overall level of disruption remains lower than during the 2021-2022 period.
Europe could begin to experience shortages in jet fuel and kerosene reserves by the end of May, potentially triggering restrictions on industrial activity similar to those seen during the COVID-19 pandemic.
The scale of the shock varies significantly under different scenarios. The ECB system is analyzing the impact through various economic models. In an adverse scenario, oil prices could rise to $119 per barrel and natural gas prices to €87 per MWh by the second quarter of 2026. Cumulative inflation would then be 1.5 percentage points higher than the forecast from December 2025, while economic growth would be 0.8 percentage points lower. In a severe scenario, oil prices could peak at $145 per barrel and natural gas at €106 per MWh, with cumulative inflation exceeding previous forecasts by 6.3 percentage points.
The current situation appears to be deviating from the baseline forecast made in March, increasing the likelihood of interest rate adjustments. While short-term inflation expectations, non-labor input costs, and firms' sales price expectations have all risen recently, medium-term inflation expectations remain stable.
Credit conditions are tightening and consumer confidence is declining. According to the ECB's Bank Lending Survey, credit standards for business loans tightened in the first quarter, and banks expect further tightening in the next quarter. Consumer confidence has dropped significantly, and business investment is expected to be impacted. Historically, European firms have tended to cut capital and R&D expenditure more sharply than their US counterparts following oil shocks.
However, household financial positions, a relatively stable labor market, and increased government spending on defense and infrastructure will help cushion the impact. The official stressed that fiscal measures should remain temporary, targeted, and precise, focusing support on the most vulnerable households and sectors to avoid pushing up long-term yields.
There is also a call to accelerate Europe's energy transition. Fossil fuels still account for over half of the EU's energy mix, but renewables now constitute 48% of electricity production, with nuclear power at 23%. Since 2015, Europe's energy intensity has decreased by 32% and is now lower than levels in Asia. The International Monetary Fund estimates that energy efficiency improvements and a cleaner energy mix in Europe have reduced the cost impact of the current shock on households by 12%.
Since the outbreak of the Iran conflict, the EU has spent an additional €27 billion on fossil fuel imports. The official called for further integration of the European energy market, advocating for more ambitious grid interconnection projects beyond the "EU Grid Action Plan" and partially joint financing for necessary investments.
Overall, the energy crisis triggered by the Middle East conflict presents multiple challenges to the eurozone economy. The future direction of the ECB's monetary policy will depend on the duration and severity of the energy shock.
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