Introduction

Welcome to this significant exchange of perspectives regarding the economic and fiscal repercussions that the Middle Eastern crisis has induced for Europe. As a member of the European Central Bank’s Executive Board, my focus today will center on the effects of this situation on the euro area’s economic activity, inflation, and the subsequent monetary policy responses necessitated by these developments.

Impact on Euro Area Economic Activity and Inflation

The initiation of a peace agreement within the Middle East is a positive step; however, the ongoing situation remains precarious, harboring potential setbacks or escalations. The long-term consequences of this conflict on inflation and economic growth in Europe hinge largely on the severity and duration of the energy price shock as well as its indirect and secondary effects.

To begin, there has been an unexpected contraction in the euro area economy in the first quarter of this year, measuring a decline of 0.2 percent primarily due to decreased national activity in Ireland. When excluding Ireland, however, growth was observed at a rate of 0.3 percent, propelled by domestic demand and exports, where both public and private consumption provided a positive contribution, despite a downturn in investments and inventories.

Nevertheless, the conflict in the Middle East has begun to hamper economic activity. Most notably, the services sector has experienced a greater decline in activity compared to manufacturing, with the prior support drawn from precautionary inventory accumulation appearing to wane as new orders stagnated by May.

Despite these challenges, the labour market demonstrates resilience, with the unemployment rate reported at a low 6.3 percent in April. Some recent surveys indicate a tendency for employers to retain workers even in the face of less favorable business environments, demonstrating an element of labour hoarding. Conversely, there has been a noticeable cooling in labour demand, coupled with expectations of a softening by both firms and households in this regard.

Projected Economic Developments

Looking forward, projections indicate a diminished outlook for domestic demand, primarily influenced by declining confidence levels and rising energy costs which are straining real incomes. Nevertheless, overall household financial health remains robust, allowing consumption to act as a primary growth driver for the near future.

In the short term, elevated energy costs and diminished confidence are likely to hinder private investments; however, investments in new digital technologies may mitigate this downturn. Furthermore, increased government expenditure related to defence and infrastructure is anticipated to bolster public investment, providing a counterbalance to the negative impacts stemming from the conflict.

According to the Eurosystem staff’s latest projections, real GDP growth is anticipated at 0.8 percent for 2026, rising to 1.2 percent in 2027 and reaching 1.5 percent by 2028.

Inflation Effects

Shifting focus to inflation, the headline rate surged to 3.2 percent in May from 3.0 percent in April. Although energy prices fell for the preceding month, annual energy inflation retained a steady 10.8 percent. In tandem, non-energy inflation incrementally rose by 0.2 percentage points to 2.4 percent, with food inflation dropping to 1.9 percent while core inflation escalated to 2.6 percent.

Domestic cost pressures manifested less intensely in the first quarter, driven by decelerating wage growth and profit margins. The ongoing energy price shock has yet to reflect substantially on wage increases, with annual growth in negotiated wages decrementing to 2.5 percent for the first quarter of 2026, down from 2.9 percent in the prior quarter.

Looking ahead, various leading indicators suggest impending inflationary pressures. Notably, Purchasing Managers’ Index input prices, import prices, food supply pressures, and selling price expectations are all signaling upward trends. The energy shock already appears to influence underlying indicators of inflation.

Monetary Policy Response

As part of our monetary policy response, the recent analysis regarding the intensity and longevity of the energy crisis led to a decision to increase the policy rate by 25 basis points this June. This action was deemed essential due to observable signs of energy price impacts filtering into broader inflation measures. Thus, even in a more favorable projection scenario, inflation is expected to exceed our target sufficiently to merit such a response.

The Governing Council remains adept at navigating the uncertainties posed by the ongoing crisis and intends to closely monitor emerging data to guide its monetary policy decisions. Notably, decisions concerning interest rates will hinge upon a thorough evaluation of the inflation outlook, related risks, and the strength of monetary transmission, without commitment to a fixed rate trajectory.

Conclusion

In summation, the crisis in the Middle East has compounded uncertainty, influencing both inflation and growth within the euro area. Rising energy costs are exerting inflationary pressure while waning confidence levels coupled with reduced real incomes are impacting economic activity. Despite these challenges, the labor market retains its resilience and household finances remain solid, with public investment poised to offer ongoing support.

Our unwavering focus is on ensuring stabilization of inflation around our 2 percent target over the medium term. Hence, future decisions will be made based on incoming data, remaining vigilant to the associated risks in both directions regarding our economic outlook.