When the war began in the Middle East and energy prices soared, Europe braced for a sharp, short economic shock. More than three months later, the region is settling in for a period of higher prices and weaker growth that could last much longer than expected.
For Europe, the recovery from the last energy shock just a few years ago has been cut short in its early stages. The economic drag is now forecast to last into next year as higher energy costs drain money from public budgets, sapping investment for more productive uses. Consumers would be left increasingly nervous about spending.
Russia’s invasion of Ukraine in 2022 cut Europe off from a critical source of natural gas, and inflation raced into the double digits. Policymakers responded by aggressively raising interest rates to thwart price growth, but that also sharply restrained the economy.
The concern today is a more subtle, but still adverse, economic hit: noticeably higher inflation and interest rates into next year at least.
“A short-term shock is being extended in time,” said Mariano Cena, senior European economist at Barclays. The longer the disruption to energy supplies from the Persian Gulf goes on, the worse the effects get, he added.
Initially, after U.S. and Israeli forces attacked Iran, and Iran responded by closing off the Strait of Hormuz, the expectation was for what economists call a V-shaped impact, with a big but short drop in growth and a strong rebound, Mr. Cena said. Now, it’s more U-shaped, where the economy is weaker for longer and the recovery is slower. Barclays recently halved its forecast for European growth this year to 0.7 percent, with just a meager pickup to 0.9 percent next year.
Before the war, Christine Lagarde, the president of the European Central Bank, proclaimed that interest rates and inflation, both at 2 percent, were in “a good place.” Investors didn’t expect rates to change all year, financial markets showed.
Now, traders are betting that the central bank will raise rates this week by a quarter of a percentage point and again later in the year. Markets are signaling that by next spring, rates will be almost three-quarters of a point higher than they are now.
The continued closure of the strait, a critical waterway for the export of energy, fertilizers and other commodities, has led to quickly rising inflation. The average rate across the 21 countries that use the euro was 3.2 percent in May, its highest level since September 2023. It was 1.9 percent in February, before the war, just below the European Central Bank’s 2 percent target.
“The impact of the energy shock is set to extend into 2027,” the European Commission said recently as it forecast economic growth next year to return only to a “modest” 1.4 percent and for inflation to be 2.4 percent. Even if energy prices have peaked this quarter, the Organization for Economic Cooperation and Development said last week, it expects inflation in the eurozone to be meaningfully above 2 percent for most of next year, higher than it projected about two months ago.
Despite the supply disruptions, Europe has not yet experienced shortages of goods, including jet fuel. Instead, the region is paying a lot more for them. Since the end of February, the European Union has spent an extra 42 billion euros (about $49 billion) on energy — about half on natural gas alone. Concerned about the cost of fertilizers, officials have announced a regionwide plan to support farmers.
As the costs mount, the European Commission, the executive arm of the 27-nation European Union, has relented on strict budget rules and given member governments some flexibility to spend more money on measures that “reduce the dependence on imported fossil fuels.”
Still, the economic slowdown will be difficult for governments to manage. Consumer confidence indicators are at lows last seen in 2022 and could go lower because inflation is starting to outpace wage growth, squeezing household budgets. And research shows that consumers, experiencing their second price shock within five years, are more sensitive and fearful of stagflation, a painful mix of high prices and stagnant economic growth.
Part of the problem is that a reopening of the Strait of Hormuz is unlikely to bring prices down quickly, economists say. Supplies will remain tight because it will take time to restart the production that has slowed or stopped since the war, and some of the lost output will take a long time to replace. That will keep prices high, especially as many countries look to build up reserves, Mr. Cena at Barclays said.
Traders are expecting oil and gas prices to slow only moderately over the next year. Futures contracts for Brent crude, the international benchmark, are trading at about $90 a barrel for the end of this year, and $80 a barrel at the end of next year. Before the war, prices were about $70 a barrel. Natural gas prices are following a similar path.
These prices “are high, but they are not extreme,” said Alfred Arnborg, an analyst at Think Tank Europa in Copenhagen. Still, they will “drag on economies who are net importers.”
Governments are “gearing up for a prolonged crisis,” Mr. Arnborg said. Some are extending their relief measures, like tax cuts on fuel, deeper into the year. Broadly, officials are getting ready to continue paying for relief measures and other costs created by higher prices. He noted, for example, that Portugal and Poland are planning new windfall taxes on energy companies.
“You wouldn’t implement windfall tax if you expected this to end tomorrow,” Mr. Arnborg said.
