Europe prepares for economic impact of Iran conflict

The U.S. and Israeli military attack on Iran could push inflation up, and stifle the already weak economic growth in Europe.

The attacks disrupted the commercial shipping in Gulf, which is a major source of fuels and petroleum products to Europe. The interruption of energy supplies immediately increased the price on financial markets.

Fuel prices will likely rise and the Bank of England and European Central Bank's outlook may be clouded, causing them to delay any rate cuts until they clear the fog of war.

What you need to know about the economic impact on Europe of the Iran Conflict:

CHOKE POINT FOR OIL GAS AND OTHER OTHER PRODUCTS

The Strait of Hormuz is located between Oman, Iran and the United Arab Emirates. It's a major gateway for Gulf exports, including oil, gas, and chemicals.

Hormuz is the route through which 20% of all oil produced in the world, including that from Saudi Arabia, United Arab Emirates (UAE), Iraq, Kuwait, and Iran, as well as large quantities of LNG from Qatar, travels.

After the invasion of Ukraine by Russia, Europe has shifted its energy imports to the Gulf region.

According to the U.S. Energy Information Administration, Britain, Italy and Belgium are among the European countries that depend the most on LNG imports via the Strait of Hormuz.

According to broker Kpler, the Gulf is a major producer of propane, butane, and ethane which are used in heating, agriculture, and as fuel.

EUROPEANS PAYING HIGHER FUEL PRICES?

Shipping data indicates that more than 200 vessels, including oil and gas tankers, have dropped anchor in the Strait of Hormuz as a result of conflict with Iran.

The oil and gas price has increased immediately. Brent futures rose nearly 8%, to $78 per barrel. Natural gas prices on the Dutch market were up 19%, at 38 euros a megawatt-hour.

In its December projection, the ECB assumed a natural-gas price of 29,6 euros/MWh this year and a crude oil price of $62.5.

The ECB will publish its new macroeconomic forecasts on the 19th of March. A cut-off date has been set for energy prices and other market indicators, which is three weeks before that -- this Wednesday.

This would mean an upgrade in its projections for energy inflation. The ECB could, however, decide to create several scenarios. This is what it did when Russia invaded Ukraine in 2022.

UniCredit said on Monday that oil prices are likely to remain at around $80 due to the abundance of oil. A major escalation would be required, such as damage to Saudi oil infrastructure to push the price up to $100.

What else is affected beyond energy supplies?

Suez Canal has been the conduit for a vast amount of trade between Europe and Asia.

In late 2023, many vessels on this route were re-routed to Africa following attacks by Yemeni Houthi rebels in the Red Sea. However, before the Iran conflict broke out, shipping companies were considering increased use of Asia-Europe's vital trade corridor.

Shipping companies began to reroute vessels away from the Suez Canal on Sunday, potentially increasing freight rates and raising the cost of imported goods.

What is the impact on growth and inflation?

According to the ECB, the impact on inflation of the recent oil price increase is much greater than its impact on growth.

In its sensitivity analysis, published in December, it argues that an increase of 14% in oil and gas prices would only lower the growth rate by 0.1% and increase inflation to 0.5%.

Next year, these impacts will be similar in magnitude and then begin to fade.

According to polls, the euro zone and UK economy are expected to grow at 1,2% and 1%, respectively, this year and then 1.4% next year. This pace is modest compared to the United States where output is expected to increase by 2.5% in 2026 and 2.0% in 2020-27.

The impact would be minimal compared to 2022 when Russia's aggression against Ukraine will cause energy prices to rise. According to a study by the European Commission, this lowered growth by 1% and increased inflation by 2%.

Energy is priced in dollars, so a relatively strong euro could also help to reduce the impact.

In a separate report, the ECB argued that the growth impact is likely to be temporary, as the economy will adjust.

How will the central banks react?

Investors have lowered their bets that the Bank of England will cut its Bank Rate benchmark by a quarter of percentage point this month. Pricing suggests a 69% likelihood, down from a 78% probability on Friday.

The ECB has already shown that it will not be taking any immediate action. It is expected to keep its rates unchanged for the rest of the year.

The central bank of the eurozone does not react to volatility in the short term and ignores temporary energy price spikes.

Any reaction will be determined by how long and how wide the conflict is. Donald Trump, the U.S. president, said that Sunday that the Iran operation might last for four weeks.

Commerzbank economists saw no impact on the economy if war only lasted a few short weeks.

If it continued for several months, they estimated that inflation in the Euro zone would likely rise by at least 1 percentage point. Economic growth would also be lower by a few tenths.

A modest increase in inflation would not affect the target.

The ECB is usually concerned if a single inflation shock begins to impact longer-term expectations of prices and spreads through to broader wage and pricing trends, via what are called second-round impacts.

The ECB will say for the moment that they are monitoring temporary volatility, but remain alert to any developments.

The market's expectations of longer-term inflation remain largely unchanged, which likely reinforces the bank’s message to wait and see.

The markets are all on the same page. This year, no interest rate changes are priced. Reporting by Francesco Canepa, Balazs Coranyi and Topra Chopra.

(source: Reuters)