The European Central Bank Amid the Middle East Conflict: The Dual Game of Inflation Expectations and Growth Risks

Geopolitical Conflict Reshapes the Macroeconomic Landscape

On March 19, 2026, the European Central Bank's Governing Council decided to keep the three key interest rates unchanged. The decision itself was not surprising, but the macroeconomic environment behind it has become exceptionally complex due to the escalation of the Middle East war. The ongoing conflict has not only disrupted global commodity markets but has also, in the short term, injected new upward momentum into inflation while casting a shadow over economic growth. In its latest economic bulletin, the ECB acknowledged that the conflict has significantly increased uncertainty about the economic outlook—inflation risks are tilted to the upside, while growth risks are tilted to the downside.

Energy Shock and the Reconstruction of the Inflation Path

In February, euro area HICP inflation rose year on year to 1.9%, up from 1.7% in January. The headline data has not yet breached the 2% target, but the new surge in energy prices triggered by the war will force inflation to climb sharply in the short term. ECB staff project that headline inflation will jump to 3.1% in the second quarter of 2026, before falling to 2.8% in the third quarter as energy commodity futures prices decline. In the baseline scenario, average inflation for 2026 as a whole will reach 2.6%, 0.7 percentage points higher than the December forecast.

More noteworthy is the transmission mechanism of inflation. Rising energy prices not only directly push up the energy component but will also feed into core inflation through cost pressures. Inflation excluding energy and food is expected to average 2.3% in 2026, higher than previously forecast. Services inflation had already risen to 3.4% in February, reflecting the lagged effects of wage costs and the indirect impact of energy. Although wage growth is expected to moderate gradually in 2026, the energy shock could generate some inflationary compensation pressure, slowing the pace of wage moderation relative to earlier expectations.

The ECB stressed that most long-term inflation expectations indicators remain anchored near 2%, which provides stability for policy. However, if energy prices remain persistently high, indirect effects and second-round effects could broaden the scope of rising inflation, which requires close monitoring. Short-term market inflation expectations have already moved noticeably higher, and the stability of long-term expectations will be a key variable determining the policy path.

Growth Resilience Encounters Geopolitical Headwinds

On the demand side, the euro area economy grew by 0.2% quarter on quarter in the fourth quarter of 2025, driven mainly by domestic demand. Rising real household incomes and a strong labor market supported consumption, construction and residential renovation activity strengthened, and business investment in R&D, software, and databases also continued to grow. This underlying resilience leads the ECB to believe that, in the absence of geopolitical shocks, the economic recovery would be self-sustaining.But the Middle East war has changed this baseline. The war's disruption to commodity markets and its impact on real incomes and confidence have forced the European Central Bank to cut its 2026 growth forecast by 0.3 percentage points to 0.9%, lower 2027 by 0.1 percentage points to 1.3%, and keep 2028 unchanged at 1.4%. Notably, this forecast is based on the energy futures price path, which assumes that energy costs will fall relatively quickly, so the growth slowdown is seen as temporary. Should energy supply disruptions be more severe and persistent, the downside would be significantly deeper.

The downward revisions to consumption and investment are the main drivers of the growth downgrade. Although the labor market remains tight, higher energy prices will erode purchasing power and weigh on consumer spending. Meanwhile, global trade policy volatility and weak external demand leave the export outlook facing persistent structural challenges. The euro area's loss of market share globally cannot be ignored, reflecting to some extent long-standing competitiveness problems.

Monetary Policy: Data Dependence and Patience on the Path

In such a complex environment, the European Central Bank chose to keep interest rates unchanged and emphasized its data-dependent, meeting-by-meeting decision-making approach. The statement noted that the Governing Council has not pre-committed to a specific rate path. This language is consistent with the communication strategy of recent years: retaining maximum policy flexibility in the face of a highly uncertain environment. Inflation will exceed 2% in the near term, but is expected to return to target in the medium term; growth is under pressure in the short term, but the labor market and fiscal spending provide a cushion. This stagflation-like combination forces the central bank to carefully balance between fighting inflation and supporting growth.

Notably, the ECB specifically stressed that fiscal responses should be temporary, targeted, and tailored. This implies that governments should not implement large-scale indiscriminate subsidies, but rather focus on the groups most affected by the shocks. In addition, the statement again urged progress on the savings and investment union, the digital euro project, and the simplification and harmonization of the single market. These structural reforms are seen as key to enhancing Europe's long-term competitiveness and strategic autonomy.

Risk Matrix and Long-Term Challenges

From a risk-balance perspective, downside risks to the growth outlook are particularly prominent, especially in the near term. The evolution of the Middle East conflict is an even greater source of uncertainty. The scenario analysis in the statement shows that if oil and gas supplies are disrupted for a prolonged period, inflation would be higher than the baseline and growth would be lower. The medium-term path of inflation will depend on the strength of the indirect and second-round effects of the energy shock.

Over the long term, this round of energy crisis has once again highlighted Europe's vulnerability to fossil fuel import dependence. The ECB has incorporated the implementation of ETS2 into its 2028 inflation forecast, which is expected to raise overall inflation by 0.2 percentage points. The green transition and energy security have become two sides of the same coin, and the war has accelerated this shift in perception.

In addition, Europe's fiscal space is also constrained. Against a backdrop of persistently high interest rates and lingering debt and deficit pressures, there is tension between increasing defense and infrastructure spending and maintaining sustainable public finances. The ECB's position is to both strengthen the economy and maintain sound public finances.

Conclusion The situation facing the European Central Bank in spring 2026 is essentially a policy trade-off under supply shocks. War-driven energy price increases are a typical negative supply shock, simultaneously pushing up inflation and depressing growth, leaving the central bank in a dilemma. However, the ECB seems inclined to view this as a temporary shock, believing that with wage growth slowing and long-term expectations anchored, medium-term inflation can still return to the 2% target. The key assumption behind this judgment is that energy prices will not continue to surge, and second-round effects remain controllable.

In an era of high uncertainty, the European Central Bank has chosen to respond with "patience." Keeping interest rates unchanged is not only a response to current data but also a cautious interpretation of complex signals. The future direction of monetary policy will depend on the war situation, the evolution of energy markets, and whether inflation expectations remain stable. For global investors and economic observers alike, this macroeconomic game in the eurozone is a microcosm of an era of global geo-economic fragmentation.