The war in Iran, launched by the United States and Israel on 28 February, has sent shock waves across the global economy, only one year on from the Trump administration’s sensational announcement of sweeping trade tariffs.
Despite overwhelming military superiority and early decapitation strikes that eliminated many high-ranking regime leaders, the Israeli-US coalition has met fierce Iranian resistance. Tehran’s closure of the Strait of Hormuz has caused an unprecedented global supply shock. Iran’s stranglehold over the Strait – a strategic chokepoint through which approximately one-fifth of the world’s oil and liquefied natural gas supply transits – is a potent weapon that threatens the stability of the global economy. In addition to oil and gas, flows of fertilisers, aluminium, helium, and other goods have also been severely disrupted, with direct consequences for prices and production chains.
The current two-week ceasefire agreed from 8 April seems extremely fragile, as the first round of talks between the warring sides, brokered by Pakistan, quickly ended in failure. The sides are very far apart – the attempts by Iran to impose a toll for passage through the Strait, in violation of the principle of freedom of navigation, are particularly alarming. In response, in another surprise move, Donald Trump announced a naval blockade of the strategic shipping corridor in an attempt to curtail Iran’s ability to finance its war effort through revenues from oil exports (with approximately 2 million barrels a day going to China).
Inevitably, traffic will be slow to resume. The International Maritime Organization estimates that 3,000 vessels are currently stranded in the Persian Gulf as they await permission to transit through Hormuz. It will take months to normalise energy flows from the Middle East, as the war has inflicted significant damage on the region’s production sites, port infrastructure, and refineries.
As a net energy importer, the Euro area economy is very vulnerable to energy shocks. We are seeing the first signs of a slowdown in the region, primarily reflected in the region’s sentiment indicators. Although still in growth territory, the Euro area Composite PMI fell 1.2 points in March from its February level, driven by a contraction in the services segment (down 1.6 points). Consumer confidence declined a sharp four points in March amid fears stoked by geopolitical tensions and the resulting intensifying inflationary pressures. That this creates an upward push to prices is already plain to see: the Euro area consumer price index accelerated sharply in March by an annual 2.5% (from 1.9% in February), fuelled by an almost 5% rise in the energy component. Inflation is expected to continue upward to top 3% over the coming months.
In a shift from the status quo at the end of 2025, markets now expect the ECB to tighten monetary policy by the end of 2026 as it grapples with the spectre of lower growth and higher inflation. Analysts are currently pricing in three rate hikes by the end of the year, which would be an aggressive stance that would push monetary policy into restrictive territory.
However, these interest rate increases would have little impact on imported inflation. The ECB’s core priority is to prevent de-anchoring of inflation expectations and manage second-round effects – where energy price rises feed into non-energy prices – especially on wages. And here, the signal from the European Central Bank’s wage monitoring tool is fairly reassuring. Its forecast is for negotiated wage increases to slow sharply year-on-year to 2.3% in 2026. Yet we cannot rule out the possibility that the energy shock will rear its head in upcoming wage bargaining.
By contrast, markets in the United States expect no more than one rate cut by the end of the year, despite softening economic momentum over the past few months. For example, household spending in January and February slowed to a trickle at under 1% (annualised quarterly growth). Inflation jumped 3.3% in March, further complicating the picture for the US monetary authorities. The Chair of the Federal Reserve recently commented that the Fed might ‘look through’ and not overreact as long as long-term inflation expectations remain well anchored.
Equity investors are betting on a rapid resolution to the crisis in the Middle East. With the mid-terms in the offing, the energy shock could exact a steep political cost for the Trump administration. Trump would gain nothing from dragging out the conflict, and the economic cost will depend on the depth and duration of the supply shock triggered by the closure of the Strait of Hormuz. But time is running out: there could be shortages of some refined products, such as kerosene and diesel.
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