European Economy: The Impact of Tensions in Iran on the Economy

■ A sharp rise in energy prices poses downside risks to the economy and upside risks to inflation. 
■ The European Central Bank (ECB) is still some distance from raising interest rates until a second wave of transmission to core inflation or a rise in inflation expectations occurs.  

   Following the US and Israeli military strikes against Iran, the Iranian navy effectively blocked the Strait of Hormuz, causing a sharp rise in energy prices. The situation remains highly uncertain, and it is difficult to predict where energy prices will ultimately stabilize. This article will explore the impact of the tense situation in Iran on the Eurozone economy and prices, as well as the possible responses from the European Central Bank (ECB). 
 
Many Eurozone countries are highly dependent on imports of energy sources such as natural gas and crude oil, and a sharp rise in energy prices will significantly worsen their terms of trade. If energy price increases persist for a long period, rising import costs will compress corporate profits; if companies pass on these costs to consumers, it will suppress personal consumption, thereby increasing downside risks to the economy. Rising market energy prices directly affect the energy price component of the Eurozone Consumer Price Index (HICP) (weighing approximately 10%). A significant portion of household energy prices in Europe is determined by long-term contracts, so changes in these prices typically lag behind market prices by several months. Furthermore, if market price spikes persist for an extended period, price increases tend to accelerate non-linearly. The composite HICP rose 1.9% year-on-year in February, slightly below the 2% inflation target and continuing to fluctuate around that level. However, if tensions in Iran persist, the inflation rate could very well exceed 2% again. Against this backdrop, financial markets have shifted their pricing of policy rates: previously expecting a rate cut by the European Central Bank (ECB) this year, they are now pricing in a roughly 20% probability of a near-term 25 basis point rate hike. 
 
However, given the increased downside risks to the economy due to weak consumption, the likelihood of the ECB raising rates solely due to energy prices pushing up the composite HICP is not high. The key lies in whether there is a stronger secondary transmission in the core HICP (excluding energy, food, alcohol, and tobacco), and whether long-term inflation expectations have changed as a result. Currently, core inflation remains slightly above 2%, but the overall trend shows that the growth rate of both goods and services prices is continuing to slow. Generally, the impact of rising energy prices on core inflation has a long lag, typically six months to a year. If the surge in energy prices is not sustained in the long term, and long-term inflation expectations remain stable, its impact on core inflation may only remain relatively small over time. 
 
The European Central Bank (ECB) vividly remembers its decision to delay interest rate hikes after the sharp rise in inflation following the 2022 pandemic, which it considered a temporary factor. However, unlike the extremely loose monetary and fiscal policies during the pandemic response, the Eurozone's policy rate is currently close to the neutral level, thus some distance from a preventative rate hike. It is expected that the ECB will maintain a wait-and-see approach in the short term, closely monitoring economic, price, and inflation expectation data.