Middle East war is slowing euro area growth and driving up inflation – Adverse impact on Finland’s economy moderated by energy transition

Decision-making at the European Central Bank (ECB) is marked by the extreme unpredictability of the operating environment. “Although a rise in headline inflation this year is unavoidable, it is still unclear what effect the war will have on inflation over the medium term. We will be closely monitoring developments in the Middle East conflict and its spillover effects on the economy. Interest rate decisions are not locked in beforehand,” says Bank of Finland Governor Olli Rehn.

Households cautious amid crisis

Household savings in the euro area have remained elevated since the COVID-19 pandemic. Analysis by the Bank of Finland shows that savings have risen in the 2020s as a result of interest rates being higher than in the period of zero rates, and because of a decline in real net wealth and the existence of public deficits. Uncertainty also leads to an increase in savings.

“The many crises since the start of the decade have increased caution among households. Developments in the Finnish economy and elsewhere in the euro area in recent years have been characterised by an increase in household savings and sluggish growth in private consumption,” says Rehn.

Euro area manufacturing burdened by energy costs

Dependence on fossil fuel imports amplifies the impact of geopolitical instability on Europe’s economic performance. Europe is struggling with subdued growth in manufacturing and high energy costs at the same time as the United States’ economy has shown dynamism and displayed an independence from energy imports. In Europe, the green transition in the energy sector is still in progress, and energy costs for European producers have stayed high since 2022. This is why the war in the Middle East will have considerable direct effects on the production costs of businesses and on the purchasing power of consumers.

“The Middle East war highlights how vital the green transition in energy is for Europe’s resilience and competitiveness – as well as being essential for the climate. Slowing the green transition now would be a serious mistake,” says Rehn. “The strength of the war’s impact on each of the euro area countries varies. The impact on the Finnish economy is moderated by the fact that Finland has made more rapid progress in the energy transition than many other countries.”

The euro area has an Achilles heel in the form of weak productivity growth. Growth in the euro area’s labour productivity has long been significantly below that of the United States, and the gap has continued to widen in recent years.

Productivity growth is a reflection of the economy’s non-cost competitiveness, and it indicates the structural strength of the economy and how well it can sustain growth in the long run.

Articles (in Finnish)