Middle Eastern conflict drives up inflation in the Eurozone! Soaring energy prices are the "culprit," and is the next step the supply chain?

The Middle East conflict is evolving into a “targeted assassination” of European consumers.

Recently, a large wave of data has come in for the euro zone, but none of it is encouraging. On the 31st, local time, data released by the European Union’s statistics office showed that in March the euro zone’s inflation rate jumped to the highest level in more than a year, reaching 2.5%, up from 1.9% previously. The figure represents a significant deviation from the trajectory seen over the past year; before this, the euro zone’s inflation rate had been fluctuating mildly around the European Central Bank’s 2% target.

As can be seen, this is the highest level of euro zone inflation since January this year, and also the steepest increase since 2022. This rise in inflation is entirely attributable to higher energy prices, reflecting that fuel retailers have quickly passed through the increase in global oil prices to the consumer side**. By contrast, euro zone core inflation—after stripping out energy and food prices—actually slowed slightly.**

Meanwhile, data released recently also showed that in March, both European economic sentiment and consumer confidence took a sharp dive. Among them, in March the EU economic sentiment index fell by 1.5 points quarter-on-quarter to 96.7, while the euro zone fell by 1.6 points to 96.6; consumer confidence also dropped sharply, hitting its lowest point since October 2023. Its main cause was that “consumers’ expectations for the overall economic situation in their country have fallen sharply.”

Zhao Yongsheng, Professor Zhao Yongsheng, a researcher at the Institute of International Open Economy Studies under the University of International Business and Economics who returned to China from the EU for academic research during the conflict, and also director of the Sino-French Social Governance Research Center at Zhejiang University of Science and Technology, told First Financial that the EU once had a relatively reasonable and healthy energy structure, but now “misfortune comes not singly.” It needs to face a dual energy crisis arising from the overlap of two geopolitical issues, which has already produced a multiplier effect. The EU and other member states have no alternative: if the situation escalates in the future, they can basically only provide energy subsidies. This conflict is a stress test for the EU, and “the reality is that when the EU faces two geopolitical crises occurring at the same time, it has weak capacity to respond effectively.”

Behind inflation, energy is the driving force

Judging by the main components of euro zone inflation, the category with the highest year-on-year growth rate in March was energy: energy prices rose 4.9% year on year, compared with -3.1% in February. Next came services at 3.2% (3.4% in February), food, alcohol and tobacco at 2.4%, and non-energy industrial goods at 0.5%.

As mentioned earlier, core inflation—after excluding energy and food prices, which have been volatile—fell by 0.1 percentage points, dropping to 2.3%.

This data highlights the dilemma facing ECB President Lagarde: high inflation may force the ECB to take rate-hiking measures, but such action would also intensify the economic problems triggered by rising energy costs.

Berenberg Bank analyst Felix Schmidt expects that in the coming months Europe’s inflation rate will peak and rise to above 3%; if the conflict escalates further, inflation could even “go well beyond 4%.”

The reason is that the longer the conflict drags on, the more likely it is that the surge in oil and gas prices will be transmitted to all other goods and services sectors that depend on oil and gas resources for production, thereby pushing up the prices of those goods and services.

Moreover, Diego Iscaro, an economist at S&P Global Market Intelligence, said that core inflation “is very likely just a matter of time” before it starts rising again, because high energy prices will be “passed through to other areas such as food and commodity prices.”

In its latest blog post on March 31, the International Monetary Fund (IMF) said that large energy-importing countries in Asia and Europe are under pressure from rising fuel and raw material costs: about 25% to 30% of global oil and 20% of liquefied natural gas must be transported through the Strait of Hormuz.

“In Europe, this shock brings back memories of the natural gas crisis of 2021 to 2022—especially because Italy and the UK, which rely on gas-fired power generation, are affected more severely, while France and Spain are relatively protected due to stronger nuclear and renewable power generation capacity.” The IMF wrote, “If energy and food prices remain high, they will push global inflation higher. Historical experience shows that a sustained surge in oil prices often raises inflation and suppresses economic growth. Over time, higher transportation and raw material costs will gradually be reflected in the prices of manufactured goods and services.”

The IMF said this impact is characterized by pronounced unevenness. In most of Asia and parts of Latin America, inflation has been relatively lower in the past, but rising energy and food prices will test the resilience of inflation expectations, especially for economies with weaker currencies and high dependence on energy imports. For Europe, if energy prices rise significantly again, it will further intensify existing pressure on the cost of living, making wage demands carry more sustained risks.

In speeches and interviews over the past few weeks, the ECB’s top management has repeatedly emphasized that when it comes to so-called “supply-side” events that are beyond their control, the ECB will not rush to raise interest rates. However, they also emphasized that once they find that companies are using the current news developments as an opportunity to raise their own prices, or once they see a sudden surge in demands for wage increases triggered by attempts to make up for losses in purchasing power, they will respond quickly.

However, also on March 31, another bad piece of news came: a monthly economic survey report released by the European Commission showed a sharp jump in the share of companies planning to raise product prices over the next year.

ECB Chief Economist Philip Lane believes another risk is that national governments themselves may provide excessive support through subsidy channels, thereby stoking inflation.

Traders expect that the ECB will raise its benchmark interest rate two to three times before the end of 2026, with each increase of 0.25 percentage points; this series of rate hikes may start as early as April. Investors expect that policymakers will try to prevent energy price increases from spilling over, and thereby transmit into wages and other price areas.

Zhao Yongsheng told reporters that regarding natural gas, the EU’s reserve level is insufficient and its reserve capacity is limited; this problem cannot be solved in the short term. Whether from an energy perspective or from the perspective of the industrial chain, the stress test for the EU caused by the Middle East conflict is troubling. The EU is probably the most fragile among developed economies. For example, in terms of energy, Europe is facing the multiple impacts of high oil prices, high gas prices, and high electricity prices.

He also told reporters that countries have different capacities to absorb shocks. Member states with nuclear power capacity, such as France, have stronger resilience under pressure. At present, France’s small modular reactor program is performing well.

Melanie Rosselet, Secretary-General of the French Nuclear Energy Summit, also said in a recent interview with First Financial that she hopes to increase investment in nuclear power at the European level. Currently within the EU, nuclear power plants generate 65 billion kilowatt-hours (TWh) of electricity, accounting for 23.3% of the EU’s total electricity generation.

Supply chain pressures intensify

The IMF also specifically discussed that the conflict is reshaping the supply chains of non-energy goods and key raw materials. Rerouting oil tankers and container ships increases freight and insurance costs and also extends delivery times. Disruptions to air traffic at key Gulf hubs not only affect global tourism, but also make trade processes more complex.

Among them, besides higher commodity prices, countries, companies, and consumers also need to deal with knock-on effects caused by supply chain disruptions. About one-third of fertilizer shipments must pass through the Strait of Hormuz. Once transport is disrupted, concerns about higher food prices intensify accordingly.

On March 30, the United Nations Conference on Trade and Development (UNCTAD) also released a report stating that the transiting volume through the Strait of Hormuz has fallen by more than 95%, leading to interruptions in the transportation of energy and fertilizer. Oil and natural gas prices have risen sharply across regions, and the increase in energy, fertilizer, and transportation costs further intensifies the pressure on food production, supply, and prices.

UNCTAD said the Strait of Hormuz is a crucial artery for global energy and fertilizer trade, carrying about one-quarter of global seaborne oil shipment volume, and also transporting large amounts of liquefied natural gas and fertilizer. Since the conflict escalated, shipping activities passing through the strait have shrunk sharply. The average daily number of vessels transiting the strait fell from 103 ships in the last week of February to single digits within just a few weeks, causing logistics through the strait to be nearly at a standstill.

“Energy markets have responded immediately. Oil prices have surged sharply, and natural gas prices in Europe and Asia have also risen rapidly— in Asia, prices have roughly doubled; Europe has also experienced similarly dramatic increases.” UNCTAD said. At the same time, since late February, tanker freight rates have risen by more than 90%. The price of bunker fuel (fuel oil) has nearly doubled, and war-risk insurance premium rates have also skyrocketed; some insurers have even completely withdrawn coverage services for vessels operating in the waters of the Persian Gulf.

“Those increased transportation and insurance costs are being passed through step by step to fertilizer prices, thereby creating knock-on effects for agricultural production and agricultural exports.” UNCTAD said. Energy, fertilizer, and food are tightly linked through production and trade. This means that supply constraints in one area will quickly spread to other areas, and thus have far-reaching impacts on food security, international trade, and economic development outcomes.

Zhao Yongsheng told reporters that, unlike China, Europe currently does not have the capability across the entire industrial chain, and Europe’s efforts to build industrial chains lag behind the United States. Apart from energy issues, the EU also faces shortages on multiple fronts such as production factors. From that standpoint, the EU will also take the initiative to coordinate and mediate the conflict, hoping to end the current turmoil in the Middle East as soon as possible.

(This article is from First Financial)