Focus
This paper examines how the conflict in Iran could affect inflation in the euro area, the United Kingdom and the United States, as of May of 2026. The conflict disrupted the supply of oil, gas and fertilisers, causing energy prices to rise sharply. The paper studies how this initial shock may spread through the economy and move inflation. It considers four transmission channels: (i) how firms adjust the prices of goods and services; (ii) how households and businesses change their inflation expectations; (iii) how governments respond through fiscal policy; and (iv) whether confidence in central banks’ inflation targets changes. The analysis uses data on prices, inflation expectations, public finances and financial market prices.
Contribution
The paper provides an early assessment of the inflation effects of the war. It applies lessons from the inflation surge of 2021–24 to the new energy shock. The analysis helps distinguish between the direct effect of higher energy prices and the wider effects that may develop over time. This distinction matters for monetary policy. Central banks must decide whether to accept a temporary rise in inflation or raise interest rates to limit its persistence. The paper also considers whether the current shock could cause a lasting change in inflation expectations. This would make inflation more difficult to control.
Findings
As of May 2026, The the conflict until then was is likely to raise inflation by about 1.5–2 percentage points in total during 2026 and 2027. Most of this increase would come from higher energy costs and their effect on the prices of other goods and services. Higher inflation expectations might add a further 0.3–0.4 percentage points. The evidence on fiscal policy is unclear. Finally, financial market data show that long-term inflation expectations remain broadly stable. The paper concludes that the inflation effect will be significant and may last into 2027. However, it is likely to be smaller and shorter-lived than the inflation crisis of 2021–24. Central banks should therefore respond carefully. Ignoring the shock entirely may allow inflation to persist, but an aggressive increase in interest rates may cause unnecessary economic damage.
Abstract
An unexpected increase in energy costs raises inflation directly through flexibly-set prices. Whether that shock amplifies to a larger and persistent rise in inflation depends on its transmission through the economy. This paper examines four channels of transmission of the Iran conflict to inflation in the EA, UK, and the US. The first is the transmission to the sticky prices in core sectors. Recent advances in menu cost models predict that inflation will rise faster than usual and monetary policy is less powerful to curb it. The second is transmission to spending, wages, and nominal returns through higher expected inflation. The empirical literature on household and firm inflation expectations points to some evidence for this amplification. The third channel is through other aggregate demand policies, especially fiscal policy. The IMF’s reassessments of the fiscal outlook provide some guarded grounds for optimism. The fourth mechanism is through an erosion in the credibility of the long-run inflation target. Data from market prices indicates that the inflation anchor has not moved. All combined, the data as of May 2026 suggests that the Iran war shock will have a significant impact on inflation that persists into 2027, but that is smaller and more short-lived than the 2021–24 inflation disaster.
- Discussion by Francesco Bianchi
- Discussion by Sarah Lein