Europe to pivot to rate hikes, slowing growth

Europe’s economy enters this energy price shock in a stronger position than in 2022. But with the energy scars from Russia’s invasion of Ukraine still fresh, we anticipate a misguided monetary policy response. We review the economic and asset class implications.

Before the Middle East conflict, Europe’s economy showed quiet resilience. Real GDP growth in the eurozone reached 1.5% in 2025. This was above expectations, and narrowed the gap with the US economy – which grew by 2.1% - from a much wider difference seen in 2023-24. Solid growth in Europe was achieved despite the negative impact of higher US tariffs. While the German economy was stagnant, activity in southern and eastern Europe rebounded.

The European Central Bank (ECB) had succeeded in bringing inflation sustainably back to its 2% target, after a 10.6% peak in late 2022. Furthermore, in this cycle, the ECB did not ‘overshoot’ with its policy calibration, as it did in 2014 when it was forced to cut interest rates into negative territory and keep them there for eight years. And the direction was encouraging: without the strikes on Iran, the ECB would have almost certainly have upgraded its growth outlook and downgraded its inflation forecast at its March 2026 policy meeting.

Before the Middle East conflict, Europe’s economy showed quiet resilience

Yet events in the Middle East forced it to do the reverse. Higher energy prices now threaten Europe’s economic outlook. Even in our base scenario of a limited duration conflict, we still expect oil prices to average USD 90/barrel over the next six months, inflicting pain on the continent as a major net energy importer. Natural gas prices in Europe – a key source of energy for heating across the continent – remain around 40% above their pre-crisis levels. Damage to key energy infrastructure in the Middle East that supplies European countries could take years to repair.

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April 9, 2026

Lasting memories of 2022

Central banks can often ignore the impact of a temporary energy shock. If energy prices stabilise or fall in line with futures prices – or contracts for delivery on future dates – then inflation will normalise automatically without a lasting impact. By the time any monetary policy tightening starts to take effect, it will just exacerbate the downward impact on growth from higher energy prices. But the ECB, with its pure inflation targeting mandate, can feel compelled to react in the face of such an event, unlike the Federal Reserve (Fed), which must also calibrate its policy to maximise employment.

In a speech last month, ECB President Christine Lagarde also noted that memories of high inflation from 2022 are still fresh in European minds. That means that companies may be quicker to pass on costs and workers push for higher wages this time round. Such ‘second-round’ effects would risk a more enduring impact on prices.

For these reasons, we now expect the ECB to raise interest rates twice in 2026, to pre-empt second-round effects from rising energy prices, starting in June. In our view, this risks a policy mistake that could leave Europe’s economy more vulnerable. Unlike in 2022, there are few signs of domestic inflationary pressures today. The labour market is in balance; wages are not accelerating; households are not spending generous fiscal handouts, as they were post-pandemic; nor is there any strong pent-up demand across the economy. Inflation expectations also remain in check.

We now expect the ECB to raise interest rates twice in 2026, to pre-empt second-round effects from rising energy prices

The ECB’s current policy rate of 2% also looks broadly ‘neutral’ – at a level that neither stimulates nor constrains growth. We thus expect the ECB to have to reverse the two 25 basis point hikes we forecast this year as the eurozone economy enters 2027 with falling price pressures and rising risks to growth. This is contrary to market expectations, which still sees the ECB holding rates around 2.50% through 2027.

A more insulated economy

The ECB was slow to raise rates when the energy shock hit in 2022 and it is now wary of repeating the error. Yet Europe’s economy is far better placed to deal with today’s energy shock than it was four years ago. Forced to sever ties with Russian gas, governments across the continent have rapidly diversified supplies and invested heavily in renewables. The region’s fiscal response also looks more targeted and measured this time round. In 2022, we estimate that governments spent 2.5 percentage points of GDP on measures to insulate companies and consumers from higher energy prices. Today, these measures are lower and far less likely to stoke inflation.

Europe’s economy is far better placed to deal with today’s energy shock than it was four years ago

Growth in Europe also has more structural support today, following a significant fiscal boost from Germany. A EUR 500 billion special fund to finance infrastructure, defence spending and decarbonisation measures will support growth for over a decade, with spillover effects across the continent. German defence orders are increasingly oriented to domestic and European suppliers. In southern Europe, growth is also being supported by continued disbursements from EU funds.

That said, the continent is still vulnerable to higher energy prices, and consumer confidence fell to a two-year low in March. With domestic demand the main driver of growth we have lowered our full-year forecast to 0.9% this year, as we expect the loss of purchasing power, rising uncertainty, and tighter monetary policy to all have a negative impact.

With domestic demand the main driver of growth we have lowered our full-year growth forecast to 0.9%

Investment implications

After three years of flat earnings for European companies, analysts expect earnings growth to rebound to 12% this year. We see these expectations as too optimistic. Higher energy prices are pressuring companies' input costs and margins at a time when pricing power is becoming more constrained. While European equity valuations have corrected, they remain above long‑term averages. A higher-for-longer interest rate environment is also likely to weigh on sentiment and cap the potential for gains from here. We keep our overall exposure to global equities neutral, and within developed markets prefer Japan’s prospects to Europe’s.

We also keep our portfolio exposures to global sovereign bonds, including those of key European economies, at underweight levels, given the risks that inflation and fiscal deficits rise. With news of the Iran-US ceasefire and negotiations, investors have started to reassess recent extreme negative sentiment towards the euro. Our 12-month EURUSD forecast remains 1.18.