LONDON — When war broke out in the Middle East and energy prices soared, Europe braced for a sharp but brief 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 after the last energy shock, which occurred just a few years ago, was halted in its early stages. The negative impact on the economy is now expected to extend into next year, as higher energy costs drain resources from public budgets, reducing investment in more productive uses. Consumers, in turn, tend to become increasingly fearful about spending.
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Russia’s invasion of Ukraine in 2022 deprived Europe of a crucial source of natural gas, and inflation reached double digits. Authorities responded by aggressively raising interest rates to contain rising prices, but this also severely slowed the economy.
The current concern is a more subtle but still damaging economic impact: significantly higher inflation and interest rates over the next year at the earliest.
“A short-term shock is lingering over time,” said Mariano Cena, chief European economist at Barclays. The longer the interruption of energy supplies from the Persian Gulf lasts, the worse the effects will be, he added.
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Initially, after US and Israeli forces attacked Iran, and Iran responded by closing the Strait of Hormuz, the expectation was for a V-shaped impact, as economists describe it: a sharp but brief drop in growth, followed by a vigorous recovery, Cena explained.
Now, the scenario looks more like a U, in which the economy remains weakened for longer and the recovery occurs more slowly. Barclays recently halved its growth forecast for Europe this year to 0.7%, with only a modest acceleration to 0.9% next year.
Before the war, Christine Lagarde, president of the European Central Bank, stated that interest rates and inflation, both at 2%, were in “a good position”. Financial markets indicated that investors did not expect rate changes throughout the year.
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Now, traders are betting that the central bank will raise interest rates this week by a quarter of a percentage point and will raise them again later this year. Markets signal that, by next spring in the northern hemisphere, interest rates will be almost three-quarters of a percentage point above current levels.
The continued closure of the strait, a key shipping lane for the export of energy, fertilizers and other commodities, has caused a rapid acceleration in inflation. The average rate in the 21 countries that use the euro reached 3.2% in May, the highest level since September 2023. In February, before the war, it was 1.9%, slightly below the European Central Bank’s 2% target.
“The impact of the energy shock is expected to extend until 2027,” the European Commission recently said in projecting that economic growth will only return to a “modest” 1.4% next year, while inflation is expected to reach 2.4%.
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Even though energy prices peaked this quarter, the Organization for Economic Co-operation and Development (OECD) said last week that it expects euro zone inflation to be significantly above 2% for most of next year, a level higher than it projected about two months ago.
Despite supply disruptions, Europe has not yet faced shortages of products, including jet fuel.
Instead, the region is paying a lot more for them. Since the end of February, the European Union has spent an additional 42 billion euros (about $49 billion) on energy — roughly half that amount on natural gas alone.
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Concerned about the cost of fertilizers, authorities announced a regional plan to support farmers.
As costs rise, the European Commission, the executive arm of the 27-nation European Union, has relaxed strict budget rules and given national governments some leeway to spend more 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 their lowest levels since 2022 and could fall further as inflation begins to outpace wage growth, putting pressure on family budgets.
Furthermore, research shows that consumers, faced with their second price shock in less than five years, are more sensitive and fearful of stagflation, the painful combination of high prices and stagnant economic growth.
Part of the problem is that reopening the Strait of Hormuz is unlikely to cause prices to fall quickly, according to economists.
Supply will remain tight because it will take time to resume production that has slowed or been halted since the start of the war, and some of the lost production will take a long time to replace.
That will keep prices high, especially as many countries look to build up their reserves, said Cena of Barclays.
Traders expect oil and gas prices to decline only moderately over the next year.
Futures contracts for Brent oil, an international benchmark, are trading at around US$90 per barrel for the end of this year and US$80 per barrel for the end of next.
Before the war, prices were close to $70 per barrel. Natural gas prices follow a similar trajectory.
“These prices are high, but not extreme,” said Alfred Arnborg, an analyst at Think Tank Europe in Copenhagen. Still, they will harm economies that depend on energy imports.
Governments are “preparing for a prolonged crisis,” Arnborg said. Some are extending relief measures, such as fuel tax cuts, for a longer period this year.
Overall, authorities are prepared to continue financing aid programs and other costs generated by higher prices. He noted, for example, that Portugal and Poland plan extraordinary new taxes on energy companies.
“You wouldn’t create a windfall tax if you expected this to end tomorrow,” Arnborg said.
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