Euro-zone growth is buckling under weight of war impact

The euro area will slow markedly while suffering the fastest inflation since 2023 as it succumbs to the energy-cost surge from the Iran war, according to the European Commission.

Issuing new forecasts for the region, the European Union’s executive arm predicted that output will rise 0.9% this year, notably below the 1.4% expansion last year, and 0.3 percentage points lower than expected in November. For 2027, it revised its outlook down to 1.2%.

Inflation is seen to average 3% in 2026, compared to only 1.9% in the previous round, and significantly above the European Central Bank’s 2% target. It’s forecast to ease again to 2.3% next year.

Brussels officials warned that in an alternative scenario, which assumes more prolonged disruptions due to the Iran crisis, price growth won’t ease and economic activity will fail to rebound in 2027.

“The conflict in the Middle East has triggered a major energy shock, further testing Europe as it navigates an already volatile geopolitical and trade environment,” Economy Commissioner Valdis Dombrovskis said.

The predictions follow repeated warnings by Dombrovskis that the region is facing the real risk of a stagflationary shock with low growth and high inflation — a label European Central Bank President Christine Lagarde has dismissed.

But with no quick end to hostilities in sight, policymakers find themselves in an increasingly tricky spot. Inflation already at 3% in April, and likely to rise further, would support the case to raise interest rates. At the same time, any tightening risks putting additional burdens on an already subdued pace of economic activity.

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The vast majority of economists surveyed by Bloomberg predict a quarter-point hike next month, and just over half expect another such step in September. Traders are betting on two to three moves this year.

At the June 10-11 meeting, the ECB will also publish new projections. In March, it predicted in its baseline that gross domestic product will rise 0.9%, with inflation averaging at 2.6%.

Survey reports earlier on Thursday, however, showed that private-sector activity in the 21-nation’s bloc shrank in May at the fastest pace in 2 1/2 years, with both Germany and France facing the risk of economic contraction in the second quarter. The euro area grew by 0.1% at the start of the year.

For Europe’s largest economy, Germany, the Commission halved its 2026 forecast for expansion to 0.6%. It revised the outlook for next year to 0.9% from 1.2%.

In a similar vein, the country’s government recently cut its own prediction for 2026 to 0.5% — a blow to Chancellor Friedrich Merz, who had predicted a “year of growth.”

While some support is still expected from hundreds of billions of euros in stimulus flowing to defense and infrastructure, those effects are increasingly being overshadowed by the war and ongoing trade tensions.

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The Bundesbank said Thursday in its monthly report that the economy will probably remain roughly flat in the second quarter, after expanding 0.3% at the start of the year.

For the period between April and June, the war is “likely to have a broader and more noticeable impact” on the economy, it said, adding that the ultimate impact depends largely on how long the conflict lasts.

The euro zone’s second-biggest economy, France, is seen growing 0.8% and 1.1% this year and next, broadly in line with the November prediction. But private-sector activity in May slumped at the quickest pace in 5 1/2 years as higher energy costs hit consumers and firms.

Some governments including Germany’s have already introduced a raft of fuel price caps, subsidies and tax cuts to provide some relief to households and companies. But interventions so far are significantly smaller than in 2022, when Russia’s invasion of Ukraine sent euro-area inflation to a record 10.6%.

“The EU must learn from past crises by keeping fiscal support temporary and targeted,” said Dombrovskis, who also called for reducing Europe’s reliance on imported fossil fuels.

The Commission highlighted that the energy shock adds new burden to public finances. The general government deficit in the EU is expected to increase from 3.1% of GDP in 2025 to 3.6% by 2027.

“This reflects higher primary deficits and an increasingly unfavorable interest-growth differential,” the Commission said.

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