• Developments in the Middle East will be a significant test of the euro area economy’s resilience after signs of better momentum early this year. The prospect of sustained higher energy pricing and deteriorating sentiment has renewed concerns around stagflation risks. The euro area inflation outlook could flip from being mildly sub-target to a moderate overshoot if current energy market moves are sustained. Recent tariff developments also reduce the scope for trade diversion to weigh on inflation. It looks a tough mix for the ECB to navigate – but ultimately upward price pressures reinforce the sense that policymakers will stand pat this year.

Rising stagflation risks pose another test of European resilience

High uncertainty around the duration of the conflict 

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 (see here). Developments in the Middle East will be a test of resilience. Stagflation risks have risen.

For now, while uncertainty is clearly elevated, initial market moves to the US/Israeli strikes and Iranian retaliation have been somewhat contained and we share the general view that de-escalation is more likely than a prolonged conflict (see here). Trump said that the conflict could last “four to five weeks”. The US has now claimed air superiority and will continue to target military sites, aiming to further weaken the Iranian regime. Domestic pressure on the US administration will also increase if energy prices remain elevated. Higher gasoline prices pose obvious political risks to the US administration with the midterms on the horizon.

But so far there are few signs of de-escalation from Iran and uncertainty is clearly high. The US goal is regime change which is generally hard to achieve without a ground presence. There is a scenario where Iran looks to draw out the conflict, using relatively low-cost drone attacks to deplete defences with the aim of forcing neighbouring countries to increase the pressure on the US to de-escalate.

From a European macro perspective, the main risk channel is clearly the price of energy the impact on inflation. There is no physical blockade of the Strait of Hormuz but elevated transit risk means that traffic has effectively been brought to a halt, putting ~20% of global oil and LNG supply at risk.

Energy pricing has been extremely volatile as markets digest the implications of developments. At the time of writing, front-month natural gas prices have surged by ~35%, with jitters around the low level of European storage, and Brent is up ~7.5%.

We’re currently not far off the ECB’s scenario from December in which it estimated that a 14.2% increase in oil prices and 20% increase in gas prices would push up HICP inflation by 0.5pp. That is a useful ballpark figure. It doesn’t consider wider supply-chain disruption, or the prospect of a weaker euro (see here). But today’s oil price move is less pronounced, as things stand. Longer-dated gas futures also show more modest moves, e.g. the year-ahead contract at ~9% (which further illustrates the market view that the conflict will prove to be relatively short-lived).

In terms of tail risks, it’s worth flagging this Dallas Fed piece from across the Atlantic which considered a severe scenario with a closure of the Strait of Hormuz and 100-USD oil. It was estimated that this would add 1.3pp to US PCE inflation. The impact on Europe, with its high energy-import share and exposure to Qatari LNG disruptions, would be larger.

Turning back to our base case, it’s important to highlight that the starting point is a relatively benign inflation outlook for the euro area. Prior to this weekend’s developments, we saw the headline HICP rate as likely to be mildly below-target this year (i.e. averaging 1.7%). But higher energy prices will pass through to consumers relatively quickly. Downside risks to euro area inflation from trade diversion effects have also increased following the US Supreme Court ruling (see here). If energy prices were sustained around current levels, the outlook could easily flip to a moderate overshoot, with plenty of tail risks around a sharper rise.

Europe’s low gas storage is cause for concern

Inflation has been well-behaved for an extended period

The ‘good place’ narrative is under threat

It’s certainly a tough position for the ECB. Stagflation risks have risen and that is always hard for central banks to navigate. Policymakers would typically look past temporary supply-side inflation pressures and tolerate moderately overshooting inflation.

But the concern now will be that household inflation expectations could become dislodged. The ECB’s 1-year ahead gauge dipped to 2.6% in January but the normalisation process has been slow – it remains both above target and above the pre-energy crisis mark. Energy prices and food prices are especially salient for household price expectations. Officials will be concerned that higher inflation becomes self-fulfilling if there is a structural shift in wage setting.

We had been arguing that an ECB cut is more likely than a hike this year (see e.g. here). Risks are now more balanced, but it would take strong evidence of resilient underlying activity over coming quarters for a hike to be considered. If anything, these developments reinforce the sense that the ECB will stand pat this year. Sometimes the best thing to do is nothing at all.

From a growth perspective, the ECB’s analysis cited above (i.e. the 14% oil and 20% gas price shock) only results in a muted drag on euro area growth (-0.1pp). We’d assume a larger impact in the case of a prolonged conflict. Without de-escalation, geopolitical uncertainty points to headwinds for business and consumer confidence. The timing of the rise in energy costs, already relatively high in Europe, is certainly unwelcome for the manufacturing sector which has been showing signs of a cyclical recovery.

We also question whether governments would be as willing to provide the sorts of generous support measures that were introduced following the 2022 energy crisis if conditions were to deteriorate. Defence spending pressures have increased and the timing of this development (as Europe emerges from winter) further reduces the immediate pressure on governments to provide energy support. Risks around our current forecast for euro area growth this year (1.2%) are tilted to the downside.