EY European Economic Outlook

European Economic Outlook: A Prolonged Inflation Shock

How the Middle East Conflict Is Reshaping Europe’s Outlook

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5 minute read 09 Jun 2026
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Economics
Geostrategy
Transformation

The Middle East conflict is exerting a broad and persistent impact on the global and European economy, extending well beyond energy markets. While uncertainty remains elevated, higher energy, fertilizer, food, and metal prices—combined with renewed supply chain disruptions—are expected to keep inflation and interest rates elevated into 2028. Euro area growth is projected to slow to 0.5% in 2026 before gradually recovering as headwinds dissipate and fiscal expansion in Germany gains traction.

The Middle East conflict will result in a protracted inflationary shock

Energy prices have risen sharply, with oil and European gas prices around 50% above pre-conflict levels. Fertilizer prices have increased by a similar magnitude, while food commodity prices have risen only moderately so far but are expected to increase further. At the same time, maritime disruptions have reignited supply chain pressures, reflected in a sharp rise in the Global Supply Chain Pressure Index.

Higher fuel prices have already added over 1 pp to euro area inflation, weighing on real incomes and consumption. Business and consumer sentiment have deteriorated markedly, indicating early effects on demand through both income and confidence channels.

Our baseline scenario assumes a gradual de-escalation of the conflict and a progressive reopening of the Strait of Hormuz.​ This would result in a gradual decline in Brent oil prices to USD 88 in 2026 Q4 and USD 75 in 2027 Q4. Prices would nevertheless remain above the pre-conflict baseline, as production will take time to ramp back up, restocking will push up demand, and some geopolitical risk premium is likely to remain embedded in prices. Under this scenario:

  • Euro area Inflation is projected to be higher by 1.2 pp in 2026 and 0.7 pp in 2027, reflecting the delayed impact of the conflict on electricity, food, and core goods prices
  • GDP growth is expected to be lower by 0.5 pp in 2026 and 0.4 pp in 2027.

Together with a sharp recession in Ireland, the Middle East conflict has prompted a downgrade in our euro area GDP growth forecast to 0.5% this year, from 1.3% in our pre-conflict forecast. Inflation is expected at 2.9% in 2026 and 2.7% in 2027, up from a previously forecast 1.9% in both years.

The impact of the conflict differs substantially across countries due to varying government responses, differences in the degree of energy price regulation, the share of energy in CPI baskets and countries’ energy mixes. The strongest inflationary impact is observed in Bulgaria, Greece and Croatia, where inflation is projected to be around 2 pp higher this year than in a no-conflict scenario. By contrast, Switzerland, Denmark and Norway are expected to see more limited effects of 0.5-0.6 pp. This inflationary impact, alongside sensitivity to global economic conditions and confidence shocks, shapes GDP’s response to the conflict. We estimate the cumulative impact on GDP growth over 2026-27 to be strongest in Czechia and Turkey, at 1.3-1.4 pp. Norway, by contrast, is likely to remain largely insulated thanks to its role as a major oil and gas producer.

Given the substantial uncertainty surrounding the future course of the conflict and its economic ramifications, we have constructed three alternative scenarios, ranging from an optimistic case of a timely and full resolution to a severe adverse scenario involving renewed escalation and a prolonged closure of the Strait of Hormuz. Under the severe scenario, in which oil prices peak at USD 150 toward year-end and remain persistently high at USD 95 in the medium term, the euro area would fall into recession, with a cumulative GDP loss of 3% and inflation peaking at 6.5%. By contrast, the optimistic scenario could still result in a relatively short-lived shock, with inflation returning to 2% as early as next year and the cumulative GDP loss limited to just 0.3%.

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Growth slowed slightly in 2026 Q1 and appears to be stalling in Q2

Excluding Ireland, euro area growth slowed to 0.2% q/q and 1.1% y/y in Q1 2026, driven by weaker consumption, investment, and exports amid slowing nominal wage growth, a pickup in inflation in March following the Middle East conflict, and a relatively harsh winter that reduced construction activity in some countries. Manufacturing output contracted in the first quarter of 2026, largely owing to a sharp decline in pharmaceuticals production in Ireland, while the services sector continues to expand at a modest to moderate pace.

 

Cross-country disparities persist.

  • Within the EU, Denmark posted the strongest GDP growth, at 5.9% y/y in 2026 Q1. However, Danish GDP is distorted by the activities of a major pharmaceutical company. The underlying pace of growth is significantly slower, though still robust, at 2.4% y/y. Growth is also relatively solid in the rest of the Nordics, with recovery finally starting in Finland, although Sweden recorded a quarterly contraction in 2026 Q1.
  • Poland and several other CEE economies (Slovenia, Bulgaria) also recorded strong 2026 Q1 growth in the 3-3.5% range, supported by robust real income gains, expansionary fiscal policy, and substantial NextGenEU spending. In the rest of CEE, growth either slowed from robust levels due to the impact of the Middle East conflict (Czechia, Croatia) or accelerated after a prolonged period of underperformance (Hungary).
  • Most Southern European economies, especially Spain, continued to outpace the rest of the EU, benefiting from a booming tourism sector, strong immigration flows, and NextGenEU disbursements.
  • Germany, Italy, Switzerland, and Austria remain among the slowest-growing economies, with growth below 1% y/y, although before the outbreak of the Middle East conflict, momentum had been gradually improving. 
  • In France and the Netherlands, growth stalled in Q1 following stronger-than-expected momentum last year. In contrast, the UK economy expanded strongly after stagnating in 25H2, although this is likely due to residual seasonality in the data. Looking beyond quarterly volatility, growth in these economies remained relatively sluggish at 1.1-1.3% y/y.
  • Economic activity is contracting in Romania, held back by fiscal tightening and rising energy prices.
  • GDP declined sharply in Ireland (-17.1% y/y in 2026 Q1) owing to falling pharmaceutical production. However, underlying growth remains strong, with modified final domestic demand up over 4% y/y.
  • In Central Asia, growth slowed abruptly in Kazakhstan (to 3% y/y), partly due to a temporary reduction in oil and gas production, while accelerating to over 8% y/y in Uzbekistan.

Growth appears to have stalled in Q2, as sentiment indicators have deteriorated sharply.

 

The labor market remains broadly balanced. Euro area employment growth has stabilized at 0.7-0.8% y/y in recent quarters, with Spain acting as the main driver in an otherwise subdued labor market. Vacancies appear to have stabilized toward the end of 2025. The unemployment rate has remained broadly unchanged, hovering near historical lows, although it continues to fall in Southern Europe while edging up in Germany and the UK. Nominal wage growth has slowed to 3.3% y/y in the euro area as real wages have caught up with productivity. CEE economies continue to record much faster wage growth than Western and Southern Europe. At the other end of the spectrum, France, Switzerland and Finland stand out with slower wage growth, which is constraining consumer spending.

Inflation, central banks and financial markets

Headline inflation in the euro area rose to 3.2% in May, driven by higher fuel prices, while non-energy components have remained broadly stable. Although fuel prices have increased broadly in line with historical relationship with oil price movements despite substantial government intervention, consumer prices of electricity, gas, and heat have so far barely moved, but are likely to increase with a lag in response to higher natural gas and coal commodity prices. While food inflation has eased in recent months, reflecting improved supply conditions before the Middle East conflict, higher fertilizer prices and rising global food commodity prices are likely to feed through into higher food prices, although this effect may materialize only next year.

Core inflation has remained stable at 2.2-2.5% in the euro area. However, the Middle East conflict has triggered substantial supply chain disruptions beyond energy markets, which, together with higher energy and metal prices, has already begun to feed through into higher core producer prices. With some delay, this is likely to translate into higher core goods consumer prices. By contrast, the pass-through of the conflict to services inflation is likely to be much more limited, as in current broadly balanced labor market conditions, wage growth is unlikely to respond materially to somewhat higher inflation.

Inflation varies substantially across countries due to differences in pre-conflict price pressures and in the initial response of energy prices.

  • In Turkey and Central Asia, the Middle East shock risks derailing disinflation, although oil producers such as Kazakhstan and Azerbaijan may use price regulation to limit pass-through.
  • In Romania, the oil shock exacerbates already high inflation resulting from previous energy price and VAT hikes.
  • Bulgaria, Croatia, and Greece have been among the EU economies most vulnerable to the Middle East conflict, experiencing the highest inflation due to relatively limited government intervention and a high share of fuels in the consumer basket.
  • In contrast, inflation remains low in Switzerland, Denmark, and Sweden because of limited wage growth (in Switzerland), FX appreciation (Sweden), tax cuts (Sweden, Denmark) and muted energy price increases given favorable energy mixes and low CPI energy weights.

Central banks have remained cautious in recent months, with all institutions except Norges Bank keeping rates unchanged. However, many central banks, most notably the ECB, have communicated readiness to hike rates unless the Middle East conflict is resolved quickly. Despite no policy moves from most central banks, global bond yields have increased, co-moving closely with oil prices, highlighting the dominant role of energy‑driven inflation expectations. UK gilts have underperformed, reflecting political instability and fiscal uncertainty, compounded by persistently above-target inflation.

In FX markets, EUR/USD has remained broadly unchanged despite episodes of heightened volatility. Meanwhile, the Hungarian forint has strengthened following the election outcome, while the Norwegian krone has appreciated, supported by elevated oil prices. In contrast, the Romanian leu has weakened following the collapse of the government. In equity markets, prices have reached new all-time highs despite the Middle East conflict, supported by strong financial results and renewed AI-related optimism.

Other forecast drivers

Although the Middle East conflict is the single most important factor shaping the economic outlook, businesses should not lose sight of other macroeconomic and regulatory developments.

  • Although the average US tariff rate has fallen following the US Supreme Court ruling, we still expect US tariffs to subtract 0.5 pp from euro area GDP growth. While the tariff regime is set to change once again after 24 July, effective tariff rate is to remain little changed.
  • Fiscal expansion in Germany continues to gather pace. However, given headwinds from the Middle East conflict and tariffs, it is likely to merely prevent German GDP from contracting, rather than generate meaningful growth this year.
  • Demographic conditions act both as an important constraint on GDP growth in Europe and as a key differentiator of growth across countries, helping explain why Spain has outperformed and Germany underperformed in recent years.
  • The AI revolution is increasingly shaping both business operations and macroeconomic developments. However, available indicators suggest that Europe is lagging significantly behind the US in AI investment. Adoption also varies widely across countries and sectors. Across countries, the Nordics and Benelux are leading, while Poland, Germany and Italy are lagging. Across sectors, IT and professional services are at the forefront, whereas construction, transportation and tourism are behind.

GDP Growth Outlook

We expect euro area growth to slow this year as the Middle East conflict weighs on household disposable income, consumer and business sentiment, and external demand, with consumer spending, private investment and exports all decelerating. Headline euro area growth is to slow from 1.5% in 2025 to 0.5% in 2026, although this is heavily affected by Ireland, where a significant recession in 2026 follows double-digit growth in 2025. Excluding Ireland, the slowdown is much less pronounced, from 1.1% in 2025 to 0.9% in 2026. Ireland excluded, growth is then expected to accelerate gradually to 1.4% in 2027 and 1.5% in 2028 as the impact of the Middle East conflict and US tariffs gradually unwinds, and fiscal expansion in Germany supports activity. Headline growth is likely to be stronger (1.6% in 2027 and 1.7% in 2028) given expected recovery in Ireland.

Country highlights:

  • Germany: Despite significant fiscal support, the economy is likely to remain effectively stagnant this year as the Middle East conflict and US tariffs weigh on private consumption, private investment and exports. Growth should resume from 2027 onward, but at 1.1-1.2% it is not expected to be spectacular as unfavorable demographics and a structural loss of industrial competitiveness limit the pace of expansion.
  • UK: GDP is expected to stagnate through the rest of 2026 as the Middle East conflict weighs on consumer spending and investment, with growth averaging 0.8%, down from 1.4% in 2025. Recovery is likely to be gradual, with growth accelerating to 1.2% in 2027 and 1.6% in 2028.
  • France: GDP growth is projected to slow to 0.6% this year before accelerating to 1.2% in 2027 and 1.5% in 2028. 
  • Italy: In 2026, growth is projected at 0.4%, led by private consumption and investment, before picking up to 0.6% in 2027, also thanks to the positive contribution of net external demand.
  • Spain: GDP growth is expected to continue moderating gradually as tailwinds from immigration and tourism fade and the Middle East conflict weighs on activity. Growth is projected to slow from 2.8% in 2025 to 2.6% in 2026, 2.0% in 2027, and 1.7% in 2028-29.
  • The Netherlands: Following a soft start to the year, GDP growth is expected to slow from 1.8% in 2025 to 1.1% in 2026 as the Middle East conflict weighs on private consumption and exports. From 2027 onward, growth should recover to 1.7-1.9% as headwinds fade. 
  • Nordics: GDP growth is expected to remain in the 1.5-2.5% range across the region, with Norway closer to the bottom and Denmark closer to the top. Activity in both countries is likely to remain volatile due to swings in the oil and gas and pharmaceutical sectors.
  • Poland: Expected to remain the strongest among the large European economies, with growth of 3.6% in 2026, supported by real income gains, NextGenEU funds, and military investment, before slowing toward 2.3-2.8% as public investment plateaus and demographic constraints weigh increasingly on potential growth.
  • Other CEE economies: Growth will remain divergent but subdued on average across the region in 2026, primarily due to stagnation in Romania, while Czechia and the Balkan economies slow due to the Middle East shock and Hungary recovers. From 2027 onward, growth is expected to strengthen and remain robust in the 2-3% range, supported by continued real income growth and industrial recovery.
  • Turkey: Growth is projected to slow from 3.6% in 2025 to 2.7% in 2026 as the Middle East conflict weighs heavily on activity, before accelerating to 3.8% in 2027 as government spending is expected to rise. Afterwards growth should settle in the 3-3.5% range.

Inflation Outlook

We expect euro area inflation to average 2.9% in 2026, 2.7% in 2027, and 2.5% in 2028, before converging to 2% in 2029.

  • The direct impact of the Middle East conflict on fuel prices will be the main reason for elevated inflation in 26Q2-27Q1, with headline inflation peaking at around 3.4% y/y late in 2026. However, supply chain bottlenecks, elevated fertilizer and global food commodity prices, and persistently higher (albeit gradually declining) energy prices will increasingly feed through into food, electricity, and core goods prices, keeping headline inflation above 2% even after the direct impact on fuel prices drops out of the annual comparison calculation from 27Q2 onward.
  • We expect core inflation to fluctuate around 2.5% from 26H2 to 28H1 and converge to 2% only in 2029. Food inflation is projected to peak at close to 4% in late 2026 and remain around 3% through 2027 and 2028.
  • In 2028, the planned extension of the ETS is expected to push up energy inflation. If it is postponed or materially watered down, headline inflation would be 0.2 pp lower, at 2.3%, in that year.

Country highlights

  • In Romania, inflation is projected to remain high in 2026 due to large energy price and VAT hikes implemented last year and the direct impact of the Middle East conflict on fuel prices, but it should ease toward 3% from 2027 onward as subdued demand and a more conservative government wage policy take effect.
  • Aside from Romania, inflation is expected to be highest in Southeast Europe (Greece, Bulgaria, Croatia), at around 5% this year, due to the relatively strong impact of the Middle East conflict.
  • Among the major economies, the highest inflation - at around 3.5% - is expected in the UK and Spain, owing to the relatively strong pre-conflict price pressures and more flexible energy prices.
  • In contrast, inflation is projected to remain very low in Switzerland, at just 0.5%, amid weak wage growth and a low share of energy in the CPI basket.
  • Sweden and Denmark are also expected to see very low inflation, at 1.1-1.3% in 2026, due to very weak underlying price pressures amid elevated unemployment, sizeable tax cuts, FX appreciation in Sweden, and favorable energy mixes. By contrast, inflation is expected to remain persistently above 2% in Norway, with rising energy prices adding to already strong underlying prices pressures.
  • The lowest inflation among the major economies is expected in France, at around 2%, due to low core inflation amid soft wage growth.
  • In Turkey, the Middle East conflict is anticipated to slow disinflation, with inflation close to 30% throughout 2026.
  • For most other countries, including Germany and Italy, we expect inflation to remain in the 2.5-3% range in both 2026 and 2027.

Monetary Policy Outlook

We expect the ECB to hike rates by 50 pb this year. While Norway and Czechia are also likely to tighten policy, other central banks in Europe are expected to remain on hold.

  • Fed: Given still restrictive interest rates, we expect the Fed to remain on hold in 2026 despite elevated inflation, before delivering 50 bp of cuts in 2027 as inflation normalizes.
  • ECB: In light of recent hawkish communication and the risk of a protracted inflationary shock, we expect the ECB to deliver two 25 bp rate hikes in June and September. Interest rates are then likely to remain higher for longer amid persistently elevated inflation. Risks are tilted toward additional tightening if more adverse Middle East conflict scenarios materialize.
  • BoE: Amid softening labor market conditions and an already elevated level of interest rates, we expect the BoE to keep rates unchanged in 2026 despite rising inflation, before delivering 50 bp of easing in 2027 as inflation normalizes.
  • SNB: We expect the SNB to keep its policy rate at 0% through end-2026, as inflation remains below 1% amid weak GDP growth and a strong Swiss franc. Rates may rise toward 0.75% thereafter as price pressures gradually build.
  • Norway: We expect one further rate hike, to 4.5%, in September, before a very gradual easing begins in 2027, with rates remaining above 3.75% until 2029.
  • Sweden: Given low headline and underlying inflation, we anticipate rates to remain unchanged in 2026 and 2027.
  • CEE: Central banks are likely to remain cautious in 2026.
    • Poland: We anticipate the National Bank of Poland (NBP) to keep the reference rate unchanged at 3.75%, given that inflation is not expected to rise persistently above 3.5%.
    • Czechia: The CNB is more hawkish despite lower inflation, and we therefore expect two rate hikes to 4% this year, which would be unwound next year, with rates eventually falling to 3%.
    • Hungary/Romania: Given higher levels of interest rates, the central banks of Hungary and Romania are expected to remain on hold this year before gradually easing from next year onward.
  • Turkey: We expect gradual easing to restart in the second half of the year, with rates falling to 31% by year-end.

Conclusion:

The Middle East conflict represents a sustained inflationary shock for Europe, operating through energy prices, supply chains, and confidence effects. While the baseline forecast envisages gradual normalization from 2027 onward, risks remain clearly tilted to weaker growth and higher inflation. Persistent cross-country divergence and tightening financial conditions will continue to shape the European macroeconomic landscape, leaving policymakers with a delicate trade-off between inflation control and growth support.

About the report

The EY European Economic Outlook is a quarterly report prepared by the EY Economic Analysis Team, led by Marek Rozkrut, Chief Economist for Europe and Central Asia. The report analyzes macroeconomic developments, including economic growth, labor markets, inflation, monetary policy and key risk factors. Each edition of the outlook includes macroeconomic forecasts for European countries and selected major economies. Both baseline and alternative scenarios are presented, with forecasts prepared using a large, integrated model of the world economy.

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