Europe Faces Stagflation: EU Commissioner Warns of Consequences of the Iran War
Despite an agreed two-week ceasefire between the United States and Iran, the European Commission believes the European Union is facing a serious economic downturn. EU Economic Commissioner Valdis Dombrovskis warned of a so-called “stagflationary shock” and announced that the Commission would revise its growth forecasts for the current year downward.
What Does Stagflation Mean?
The term stagflation is a combination of the words “stagnation” and “inflation” and describes an economic scenario that is considered particularly difficult to combat. It refers to a combination of two simultaneously occurring, essentially opposing phenomena:
- Economic stagnation or contraction: Growth slows sharply or stalls, businesses invest less, and unemployment rises.
- Rising inflation: At the same time, goods and services become more expensive, and the purchasing power of the population declines.
Normally, weak growth is accompanied by low inflation, because demand falls. In a stagflation, however, external factors — such as sharply rising energy prices — drive up costs while the economy simultaneously weakens. Central banks then face a dilemma: if they raise interest rates to combat inflation, they further dampen an already weak economy.
The European Commission’s Calculations
Before the outbreak of the conflict, the European Commission had forecast EU economic growth of 1.4 percent for the current year, along with inflation slightly above 2 percent. These figures are now likely to turn out significantly worse. The Commission has modelled two scenarios, the results of which it shared with the Financial Times:
| Scenario | Assumption | Impact on Growth | Impact on Inflation |
|---|---|---|---|
| Scenario 1 (favourable) | Energy prices return to pre-war levels by end of 2026 | Minus 0.4 percentage points in 2026 | Plus up to 1 percentage point in 2026 |
| Scenario 2 (unfavourable) | Energy prices remain elevated for longer | Minus 0.6 percentage points in 2026 and 2027 | Plus up to 1.5 percentage points in 2026 and 2027 |
The Commission’s official updated growth forecasts are due to be published in May.
Europe’s Vulnerability Due to Energy Dependence
The conflict has exposed a structural weakness of Europe: the continent is heavily dependent on energy imports. Compounding this are significant disruptions to global shipping routes, which are making the movement of goods more expensive and slower. Particularly critical is the situation at the Strait of Hormuz, one of the world’s most important oil and gas transit routes. According to reports, Iran is demanding toll fees in cryptocurrency from shipping companies for passage through the strait, even during the ceasefire.
“It is certainly a welcome step towards de-escalation and is expected to bring some relief in the energy crisis as well. But there is of course still great uncertainty regarding the economic impact of the war in Iran. It is clear that we are facing a stagflationary shock.” (Valdis Dombrovskis, EU Economic Commissioner)
Some EU member states have already taken countermeasures. Italy, Poland, and Spain have, among other things, cut fuel taxes to ease the burden on households and businesses. Several countries are also examining the possibility of restarting decommissioned nuclear power plants.
Warning Against Excessive Government Spending
However, Dombrovskis urged member states to maintain fiscal discipline. Given already high levels of debt, fiscal room for manoeuvre is limited. Relief measures must be “clearly time-limited and targeted, with the smallest possible impact on the budget,” the Commissioner said.
Italy, which had hoped to exit the EU’s so-called excessive deficit procedure, is likely to miss that goal: the national statistics office recently reported a budget deficit of 3.1 percent of gross domestic product, just above the EU threshold of below 3 percent. Rome had called for the EU’s fiscal rules to be temporarily suspended, as was done during the COVID-19 pandemic. Dombrovskis, however, firmly rejected this request: the relevant clause only applies in the event of a “severe economic downturn,” which is not currently the case.
Long-Term Consequences Despite the Ceasefire
Experts warn that the economic effects of the conflict will continue to be felt for a long time, even if the ceasefire holds. An economist at the bank HSBC summarised the situation in a note to clients as follows:
“European economies are only at the beginning of their trial.”
Whether a lasting easing of energy prices can be achieved depends, in the view of investors, largely on whether Iran relinquishes its control over the Strait of Hormuz once the two-week ceasefire expires.
