The new energy shock: economic scenarios and policy implications

Keynote speech by Piero Cipollone, Member of the Executive Board of the ECB, at the 2026 Sustainable Development Festival

Milan, 6 May 2026

Thank you for the opportunity to speak at the Sustainable Development Festival.

Today, I will argue that the current energy crisis serves as a powerful reminder that Europe's path to robust and stable economic growth is only as viable as it is sustainable. We should care about sustainability not just, or even primarily, to protect the environment, but also because it is a key condition for our economic stability and prosperity. And in doing so, we Europeans can pursue our own specific interests, while also contributing to the common good.^[1]

We are facing the second major energy shock in just four years. Following on from Russia's invasion of Ukraine in 2022, the war in Iran and the Middle East is now further hampering energy flows. And the closure of the Hormuz Strait is starting to disrupt global supply chains.

This shock has interrupted a positive, hard-won trend of stable prices and robust growth in the euro area over the last two years.^[2] Inflation had returned to target. Real incomes had recovered from the previous energy shock, boosting consumption. Investment was on the rise. And domestic demand was more than making up for the decline in net exports stemming from higher US tariffs and the surge in imports from China. Overall, the European economy was showing strong resilience to the prevailing trade uncertainty.^[3]

Now, this resilience is again being put to the test.

The war in Iran and the Middle East is already having an impact on prices and quantities. Oil and gas prices have surged, feeding into short-term inflation. And supply tensions have started to emerge, for instance in relation to jet fuels.

If sustained, the current shock could have significant implications for our medium-term inflation objective and the euro area's economic outlook.

So how can we best navigate this environment?

In the short term, we face considerable uncertainty over the evolving geopolitical situation. To support our decisions, we have developed economic scenarios, in line with the lessons learned from our experience in recent years.^[4] As geopolitical developments and their implications unfold, these scenarios provide us with a benchmark to assess the situation in real time, informing our monetary policy decisions. We are paying attention to possible signs of a de-anchoring of inflation expectations or of a break in economic dynamics, as we seek to ensure inflation returns to our target in a timely manner without unnecessary costs.

While monetary policy can ensure the return of inflation to target over the medium term and fiscal policy smoothen the hit to economic activity, there are inevitable trade-offs associated with the response to negative energy supply shocks, which must be carefully calibrated. Over a longer time horizon, however, the broader policy implications are clear. Geoeconomic shocks have major effects on prices and the economy. And our dependency on fossil fuels multiplies these effects. The current energy crisis thus underscores the pressing need to further reduce our reliance on fossil fuels not only because of climate risks but perhaps even more clearly because of energy security risks that are likely to be with us for some time.^[5] Decarbonising will make us better off, not worse off.

In my remarks today, I will discuss the renewed energy shock and its short- and medium-term impact on inflation and the economy, before turning to the policy implications.

The energy shock and its short-term impact

Let me start by putting the current shock in perspective.

Geoeconomic tensions have spiked in recent years, reaching their highest levels since the launch of the euro (Chart 1). These disruptions to international economic relations, primarily affecting trade and energy, have arisen in a world that has never been as interconnected as it is today, thus magnifying their impact.

The short-term effect of the war in Iran and the Middle East on global oil supply is larger than in the three previous energy crises (1973, 1979 and 2022) combined.^[6] Even after accounting for mitigating measures, such as the rerouting of oil flows through pipelines and the release of strategic reserves, the net decline in supply is estimated at around 12 million barrels per day,^[7] representing about 11% of the prewar global oil supply. Restoring supply after the war will take time given the damage to major oil facilities. As a result, oil prices have surged (Chart 2).

Gas prices have also increased, but so far by much less than after Russia's 2022 invasion of Ukraine. This is important in the European context given how closely correlated electricity and gas prices are.

At the same time, the closure of the Strait of Hormuz has affected the trade of numerous critical commodities and chemical products, such as liquefied natural gas, refined oil products, aluminium, helium, sulphur and fertilisers. This constitutes a negative supply shock for the euro area economy, reducing the availability and pushing up the price of critical inputs. There is already some evidence of longer delivery times, rising input costs and supply shortages, albeit still contained compared with those seen between 2021 and 2022 (Chart 3).

The shock has pushed consumer prices higher. Annual headline inflation rose to 3% in April (Chart 4), driven by a 10.9% increase in energy prices, whereas inflation excluding energy fell to 2.2%.

By pushing up consumer prices and exacerbating uncertainty, the shock is likely to reduce real incomes and hurt domestic demand, which had been the motor engine for the euro area economy in recent quarters.^[8] Indeed, surveys point to a significant hit to economic sentiment (Chart 5). In particular, consumer confidence has dropped sharply, which will dampen consumption.^[9] And the empirical evidence suggests that the shock will weigh on business investment, with European firms significantly cutting capital and R&D expenditure in the wake of an oil shock, unlike their US counterparts.

In addition, the energy shock is also a terms-of-trade shock, further increasing the prices of euro area imports relative to exports, thus weighing on net exports.

Meanwhile, the impact on economic activity could be compounded by the endogenous tightening of financing conditions, as banks become increasingly concerned about the economic risks facing their customers. Credit standards for loans to firms have already tightened in the first quarter, according to our latest bank lending survey.^[10] This warrants close monitoring, especially as banks anticipate further tightening, which is expected to accelerate in the next quarter.

On the other hand, the shock could be cushioned somewhat by households' solid financial position, a still resilient labour market and government spending on defence and infrastructure. These factors, alongside business investment in new digital technologies, have underpinned domestic demand in recent quarters.

Fiscal measures could also provide support, though they should remain temporary, tailored and targeted at the most exposed households and sectors. Otherwise, concerns about the cost to public finances and their sustainability could lead to an increase in long-term yields that would immediately weigh on private investment.

So far, the impact on economic activity has been felt through energy prices, confidence effects and financing conditions. However, Europe could start running out of jet fuel and kerosene reserves by the end of May,^[11] potentially leading to material restrictions on the activity of several industries akin to those seen during the COVID-19 pandemic.

The medium-term outlook: working with scenarios

The magnitude of the macroeconomic effects will depend on the intensity, duration and propagation of the shock. To assess these effects, the Eurosystem has turned to economic scenarios. They provide us with a reference point to assess ongoing developments in a highly uncertain and volatile environment.

Under the baseline scenario in our March staff projections, higher energy prices are likely to keep inflation well above 2 per cent in the near term. Although recent inflation has been in line with these projections, there are clear upside risks in view of the latest oil price developments.

There are also clear downside risks to growth, which already came out below our projections in the first quarter of the year, at 0.1% quarter-on-quarter. For instance, the drag from the ongoing shock could further intensify if shipping disruptions were to cause input shortages, forcing euro area firms to curtail their output.

The adverse and severe scenarios we outlined in March seek to capture the risks to the inflation and growth outlook.^[12] This approach has since been followed by other institutions, such as the IMF.^[13]

Our projection's adverse scenario assumes a much sharper increase in energy prices, with oil and gas prices peaking at USD 119 per barrel and €87 per MWh, respectively, in the second quarter of 2026. It also incorporates stronger indirect and second-round effects, as well as greater uncertainty and heightened adverse international spillovers, such as lower foreign demand. In such a scenario, inflation is cumulatively 1.5 percentage point higher until 2028 than what we projected last December, while growth is cumulatively 0.8 percentage point lower.

Compared with the adverse scenario, the severe scenario assumes an even stronger and more persistent energy price shock, with oil prices peaking at USD 145 per barrel and gas prices at €106 per MWh in the second quarter of 2026, before declining at a much slower pace. It also envisages greater uncertainty and even stronger indirect and second-round effects. In such a scenario, inflation is cumulatively 6.3 percentage point higher until 2028 than what we projected last December.

The significant difference between the adverse scenario and the severe scenario highlights the importance of the intensity, duration and propagation of the shock as we seek to assess its impact on the inflation outlook (Chart 6). We will update these scenarios in our June projections.

Policy implications

The role of monetary policy: preserving price stability in the medium term

This approach in turn helps inform our monetary policy decisions.

Last week we decided to keep our policy rates on hold. Our starting position allows us to gather more information on the intensity and likely duration of the shock. Inflation was back to our 2% medium-term target, supporting the credibility of our monetary policy. Economic growth was close to potential and our policy rates were within the estimated neutral range where they neither stimulate nor put a break on the economy. These are important differences compared with the situation we initially faced at the start of the 2022 energy shock. And today we are not facing a positive demand shock similar to the one that occurred when the economy reopened after the pandemic.

At the same time, memories of the previous energy shock are still fresh, and could lead to a faster adjustment in inflation expectations. Short-term inflation expectations, non-labour input costs and firms' selling price expectations have indeed moved higher. At the same time, medium-term inflation expectations have so far remained well anchored (Chart 7) and measures of underlying inflation remain close to our target.

We are nevertheless paying attention to possible signs of a de-anchoring of medium to long-term inflation expectations. In particular, we will be looking at the indirect pass-through of higher energy costs to the broader consumption basket prices and possible second-round effects.

A key consideration will be the pricing power of firms. A weaker economy, where the supply shock triggers a negative demand shock, would reduce this pricing power. A more resilient economy may instead leave more room for price increases. The latest PMI surveys point to a contraction of activity in services. While manufacturing has so far been more resilient, this partly reflects a buildup of safety stocks in response to supply chain disruptions.

Regarding wages, we will be closely monitoring their development, but wage-setting typically lags behind price-setting. At this stage our wage tracker continues to point to wage moderation amid a cooling labour market. After the previous energy shock, we actually saw a significant contraction in real incomes, resulting in an initial reduction of the labour share of income and the relative price of labour.^[14] In today's environment, the adoption of artificial intelligence (AI) could further weigh on the labour share, primarily through wage compression.^[15] For example, in Italy 42% of workers fear that they could be replaced by AI.^[16]

Overall, the current situation seems to be drifting away from our March baseline projections, which increases the likelihood that we may need to adjust our policy rates.

Increasing Europe's resilience to energy shocks

Faced with an energy shock, monetary policy can anchor expectations and ensure the return of inflation to target over the medium term, while fiscal policy can smoothen the hit to economic activity. But they involve costs no matter how smartly and carefully engineered they may be. These costs cannot be ignored on the grounds of their low frequency. On the contrary, they are amplified by the fact that supply shocks are becoming more frequent owing to the use of critical inputs as leverage in the geostrategic power struggle.

In response, Europe needs to increase its resilience to energy shocks. This requires further reducing our dependence on fossil fuel, which still represents more than half of the EU's overall energy mix (Chart 8, panel a).

A more sustainable energy mix would benefit price stability. It would support disposable income for European households. And it would reduce the energy bill for European firms, sustaining not just traditional energy-intensive sectors but also new ones, such as data analytics, AI and data centres that are currently the source of growth in other economies. At the same time, a more sustainable energy mix would contribute to the common good of combatting global warming by abating CO2 emissions.^[17]

Europe is already less exposed than it was in 2022 thanks to the rapid advance of renewables. As of 2024, more than two-thirds of EU electricity generation comes from low carbon sources, which is much more than in the United States and China. Renewables is the largest contributing source at 48%, with nuclear energy accounting for another 23%.^[18]

From 2015 to 2025, the EU's energy intensity - that is, energy expenditure as a share of GDP -declined by 32% and now stands below that of Asian economies (Chart 8, panel b). Energy consumption is 10% lower than in 2021, and gas import volumes have fallen by 20%.^[19] While this partly reflects the impact of higher energy costs on the European manufacturing sector, it is also the result of efficiency gains. Overall, the IMF estimates that Europe's energy efficiency gains and cleaner energy mix over the past five years have reduced the cost of the current shock by 12% for households at current prices.^[20]

In particular, Europe has become less dependent on energy imports from Gulf countries and is now significantly less exposed than Asian countries (Chart 9, panel a). This implies that output at risk from the current disruptions is lower than in Asia but still higher than in the United States, which has become a net petroleum exporter. This is illustrated by a fragmentation scenario in global commodity markets, in which supply shortages propagate through the global production network and create broad-based production constraints (Chart 9, panel b).

However, the current shock shows that further efforts are needed to increase Europe's energy security and resilience to further shocks. According to the President of the European Commission, the EU has spent an extra €27 billion on fossil fuel imports since the war in Iran started.^[21]

Looking ahead, Europe needs to stay the course on the energy transition and further integrate its energy market.^[22] In particular, interconnecting energy grids and coordinating the energy supply would help it reduce the risks stemming from the local volatility of renewable energy sources, which are available at different times across the euro area. It would also make it possible to leverage the diversity of energy mixes across Member States.

The European Grids Package is an important step in this direction. But if we want to establish a single market for energy and overcome the intrinsic difficulties of transporting electricity - by increasing storage capacity, for instance - then we need to be more ambitious. Given the investments required for this and the potential common benefits - as documented in the Draghi report^[23] - there is a case for jointly financing at least a portion of them.^[24]

There could be a silver lining for the European economy. If energy shocks push us to innovate and do more with less fossil fuel energy, not only will price stability benefit but productivity growth will increase.

Europe already plays a leading role in sustainable finance. Green bonds are seeing the fastest growth in international euro-denominated bond issuance, and the euro has surpassed the US dollar in international green and sustainable bonds. Looking ahead, Europe could position itself at the forefront of financial instruments designed to hedge against sustainability-related risks.^[25]

Conclusion

Let me conclude.

The war in the Middle East has led to a sharp increase in energy prices, pushing up inflation and weighing on economic sentiment.

The implications of the war for medium-term inflation and economic activity will depend on the intensity, duration and propagation of the energy price shock.

We are using scenarios to assess these implications, even as uncertainty continues to cloud future geopolitical developments. These scenarios allow us to use informed judgement as we assess incoming information and decide on the appropriate monetary policy reaction.

However, the monetary and fiscal responses to energy supply side shocks are costly no matter how smartly and carefully engineered they may be. Other tools are needed, as one thing is certain: sustainability contributes to stability. To be more resilient to energy shocks, we need to stay the course for the energy transition in the name of price stability and economic prosperity.

Thank you for your attention.