When war began in the Middle East and energy prices soared, Europe braced itself for a short, sharp economic shock. More than three months later, the region is adjusting to a period of higher prices and weaker growth that could last much longer than expected.
For Europe, the recovery from the last energy crisis 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, undermining investment for more productive uses. Consumers would be increasingly nervous about spending.
Russia’s invasion of Ukraine in 2022 cut off Europe from a critical source of natural gas and inflation soared into double digits. Authorities responded by aggressively raising interest rates to thwart price growth, but that also sharply constrained the economy.
The concern today is a more subtle, but still adverse, economic blow: inflation and noticeably higher interest rates at least through next year.
“A short-term shock is dragging on over time,” said Mariano Cena, senior European economist at Barclays. The longer the disruption to energy supplies from the Persian Gulf lasts, the worse the effects will be, he added.
Initially, after U.S. and Israeli forces attacked Iran, and Iran responded by closing the Strait of Hormuz, the expectation was what economists call a V-shaped shock, with a large but brief drop in growth and a strong rebound, Cena said. It is now 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 only a meager rebound to 0.9 percent next year.
Before the war, Christine Lagarde, president of the European Central Bank, proclaimed that interest rates and inflation, both at 2 percent, were in “a good place.” Financial markets showed that investors did not expect rates to change throughout the year.
Now, traders are betting the central bank will raise rates this week by a quarter percentage point and again later this year. Markets are signaling that next spring rates will be almost three-quarters of a point higher than now.
The continued closure of the strait, a vital waterway for the export of energy, fertilizers and other raw materials, has led to a rapid rise in inflation. The average rate in 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 will last until 2027,” the European Commission said recently, predicting that economic growth next year will return to only a “modest” 1.4 percent and that inflation will be 2.4 percent. Even if energy prices have peaked this quarter, the Organization for Economic Cooperation and Development said last week, it expects eurozone inflation to be significantly above 2 percent for most of next year, higher than it projected about two months ago.
Despite supply disruptions, Europe has yet to experience shortages of goods, including jet fuel. Instead, the region is paying much more for them. Since the end of February, the European Union has spent an additional 42 billion euros (about $49 billion) on energy, about half of it on natural gas alone. Concerned about the cost of fertilizers, officials have announced a regional plan to support farmers.
As costs rise, 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 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 decline because inflation is starting to outpace wage growth, tightening household budgets. And research shows that consumers, experiencing their second price shock in five years, are more sensitive to and fearful of stagflation, a painful combination of high prices and stagnant economic growth.
Part of the problem is that a reopening of the Strait of Hormuz is unlikely to lower prices quickly, economists say. Supplies will remain tight because it will take time to restart production that has slowed or stopped since the war, and it will take a long time to replenish some of the lost production. That will keep prices high, especially as many countries look to build up reserves, Barclays’ Cena said.
Traders expect oil and gas prices to slow only moderately over the next year. Futures contracts for Brent crude, the international benchmark, are trading at around $90 a barrel by the end of this year and $80 a barrel by the end of next year. Before the war, prices were around $70 a barrel. Natural gas prices are following a similar path.
These prices “are high, but not extreme,” said Alfred Arnborg, an analyst at Think Tank Europe in Copenhagen. Even so, “they will drag down economies that are net importers.”
Governments are “preparing for a prolonged crisis,” Arnborg said. Some are expanding their relief measures, such as fuel tax cuts, as the year progresses. Generally speaking, officials are preparing 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 a windfall tax if you expected this to end tomorrow,” Arnborg said.
