In the last two years, after an unprecedented cycle of policy rate increases, the European Central Bank (ECB) has been successful in stabilizing inflation near its target. The most aggressive tightening sequence in the history of the ECB had taken the benchmark deposit interest rate to 4%, as a response to the major post-Covid inflationary shock and the Russia-Ukraine war that boosted commodity prices.
Interest rate cuts finally began in June 2024 at a cautious pace, as ECB officials gained confidence in diminishing price pressures. This brought the deposit rate to 2%, a level in the “neutral range” that implies that monetary policy is neither stimulating nor restraining economic activity. At the beginning of this year, with inflation fluctuating narrowly around the 2% target mark, the outlook pointed to a stable monetary stance for 2026, and economic growth recovering, with real GDP expanding 1.5% this year.
However, a new major energy shock linked to the ongoing conflict in the Middle East is reshaping the macroeconomic outlook since the beginning of March 2026. As the conflict intensified, severe supply disruptions and constrained shipping routes led to sharp surges in oil and gas prices. Brent crude prices exceeded USD 120 per barrel and afterwards moved close to USD 115 per barrel.
The Euro Area is particularly sensitive to natural gas prices, as gas not only constitutes a major share of energy imports, but also acts as a key price-setting fuel in electricity markets. Thus, higher and more persistent energy prices are set to lift inflation, forcing the ECB to reassess its policy path.
The ECB operates under a clear and singular mandate of maintaining price stability. This contrasts with the US Federal Reserve, which follows a dual mandate of price stability and maximum employment. As a result, the ECB is expected to react more decisively when inflation deviates from target, even if growth conditions weaken. In this context, the balance of risks has shifted towards ECB tightening in the near term.
Going forward, the high degree of geopolitical uncertainty makes it impractical to provide a single-scenario forecast. In our view, there are two likely scenarios, baseline and adverse, with largely different economic and monetary policy implications.
European Central Bank Policy Interest Rate
(%, ECB deposit rate)
Source: European Central Bank, QNB Economics
In the relatively more benign baseline scenario, the geopolitical situation stabilises within a month or evolves into a lower-intensity conflict with a reopening of the Strait of Hormuz. In this scenario, energy prices would partially retrace, and Brent crude could fall back to USD 80 per barrel, which still includes a sizable risk premium compared to the pre-conflict situation and a reduced global oil supply capacity caused by the damaged energy infrastructure.
Euro Area Consumer Price Inflation
(%, headline series, year-over-year)
Source: Eurostat, QNB Economics
Under these conditions, the pressure on prices would prove temporary, with inflation reaching 2.5% to 3%, mainly impacting energy related prices, while the effect on other goods and services would remain limited. This would allow the ECB to follow a less aggressive stance. With the growth outlook already subdued, the ECB could even refrain from tightening and keep rates on hold. The energy shock would be interpreted as transitory, with limited implications for the medium-term inflation outlook.
In a more adverse scenario, where the crisis persists for several months and energy prices remain elevated for an extended period, inflationary pressures would become persistent and also influence production costs. Higher energy costs would first feed directly into inflation, where energy accounts for over 9% of the consumer price basket. Additionally, costs would gradually pass-through and impact other non-energy goods and services, increasing the risk of “second-round” effects.
Under this scenario, inflation could reach 4.5% and remain above target for over a year, forcing the ECB to react. Given its primary mandate, the ECB would likely prioritise the stabilization of inflation expectations, even in the face of weaker growth, taking the benchmark deposit rate to 2.75% by the end of this year, a level that is considered “restrictive” for economic activity.
All in all, the ECB faces a challenging policy dilemma driven by an external energy shock that is pushing inflation higher while weighing on growth. A prolonged period of elevated energy prices would likely trigger a tightening cycle, while a more rapid normalization would allow the ECB to remain on hold. The next four to six weeks will be critical in determining which scenario materializes, as incoming data on energy markets and inflation dynamics will provide clearer signals on the macroeconomic outlook.
