The International Monetary Fund said on Tuesday that the euro zone will see growth slow and inflation pick up this year, necessitating additional monetary tightening from the European Central Bank even if the economic shocks from the Iran war dissipate by mid-year.
According to the IMF’s World Economic Outlook, the bloc's heavy reliance on imported energy leaves it particularly exposed to surges in energy prices. That vulnerability is compounded by strains on access to key resources stemming from Russia’s war in Ukraine, the IMF said, and by a real appreciation of the euro versus currencies of countries exporting similar goods. Those combined forces are expected to weigh on manufacturing activity.
Growth is now projected to decelerate to 1.1% this year, down from a 1.4% pace in 2025 and below the 1.3% projection published in January, the IMF reported. The fund said the hit from the Iran conflict more than offsets a stronger-than-expected expansion at the end of last year.
The IMF noted that planned increases in defence spending will provide some offset to the economic drag, but cautioned that the planned ramp-up in such spending is gradual and the resulting boost is likely to appear later rather than immediately.
On the inflation front, the IMF’s baseline projection assumes the Iran war will be limited in duration, intensity and scope and that disruptions will fade by mid-2026. Even under that assumption, consumer prices are forecast to rise to 2.6% in 2026 from 2.1% last year.
In response to the projected pick-up in inflation, the IMF said the ECB’s current 2% deposit rate would most likely need to be increased by 50 basis points over the course of 2026. That anticipated move aligns with market expectations, and investors have already priced in a rate hike by June on the belief that the ECB will want to signal early it will not allow inflation to spread beyond energy-related pressures and develop into a self-sustaining upward trend.
At the same time, the IMF emphasized that outcomes worse than its baseline remain possible. Its "adverse" and "severe" scenarios point to larger global growth losses and greater inflationary pressure than those in the baseline.
Contextual note: The IMF’s assessment ties together energy dependence, lingering effects of higher energy prices since Russia’s invasion of Ukraine, and the euro’s relative strength as key channels through which growth and prices will be affected. The fund also flags that defence spending increases will only partially and gradually offset the negative effects.