Europe’s economic outlook has deteriorated significantly, driven by war-related energy disruptions that are expected to force tighter financial conditions, according to the latest International Monetary Fund report.
The IMF says the European economy remains resilient but increasingly exposed to external shocks amid an energy crisis linked to the war in Iran and the closure of the Strait of Hormuz.
It urges swift reforms, including completing the EU single market by better linking power grids, deepening financial integration and boosting productivity.
Oil prices have surged by around 70%, while European gas prices remain roughly 45% above pre-war levels. Although less severe than the 2022 shock, the increases are still expected to weigh heavily on growth, the IMF warns
Europe’s long-term shift towards renewables — now accounting for over half of electricity generation — has helped soften the impact of the energy shock, but the IMF says it offers only partial protection.
Growth forecasts have been downgraded, with the euro area now expected to expand by just over 1% in 2026, down from around 1.4% before the Iran war, according to IMF projections. Meanwhile, inflation remains high, reflecting the persistent cost pressures from energy and supply disruptions.
Fiscal health depends on the conflict’s duration
The IMF’s outlook depends heavily on geopolitical developments, as the institution warned warning that a short Middle East conflict could limit the damage, but a prolonged crisis could tip Europe into recession.
“Overall economic impact will depend on how the conflict in the Middle East will evolve, particularly on energy supplies and infrastructure,” Economy Commissioner Valdis Dombrovskis said at a press conference on Monday evening following a meeting of eurozone finance ministers.
He cautioned that the bloc cannot afford to “repeat the mistakes of the past,” stressing that any support measures must be temporary, targeted and not add to aggregate demand.
Europe was already grappling with elevated energy prices before the US-led war against Iran began disrupting global energy markets on 28 February.
European industry was paying two to three times as much for energy as competitors in the United States and China. This persistent gap reflects a structural vulnerability rather than a temporary imbalance, the IMF warned.
Keep the ETS, revamp the electricity grid, IMF suggests
Against this backdrop, maintaining momentum on energy reform is crucial.
The IMF report urges the EU to stay committed to its carbon market, the Emissions Trading System (ETS), which had been on the brink of collapse but is viewed by the IMF as supporting continued progress in the adoption of wind and solar power.
It warns that abandoning ETS could jeopardize hard-won progress in decarbonisation.
Beyond this, Europe must complete its internal energy market, the IMF said, with the Commission’s grids package proposed last December being an “important step”.
Having a revamped electricity grid and storage are crucial for the EU to succeed in its energy transition and will dominate the bloc’s policymaking — and probably political feuds — over the next months, as Commission President Ursula von der Leyen asked the Parliament and the Council, the EU co-legislators, to have a political agreement on the grids’ proposal by the summer.
European preference could backfire
The IMF report also points to the Commission’s proposed Industrial Accelerator Act (IAA) saying it contains useful measures, including efforts to diversify supply chains.
However, it also warns that “Made in Europe” procurement rules and foreign investment conditions linked to local value creation could distort markets and weaken comparative advantage.
Protecting strategic industries is a legitimate objective, the IMF says, but it must be guided by disciplined cost–benefit analysis.
Policy instruments vary significantly in terms of efficiency and cost, and interventions should be limited to cases where markets alone cannot adjust effectively.
The report also warns against common policy pitfalls, noting that loosening competition rules, pursuing uncoordinated industrial strategies, or scaling back climate commitments could ultimately weaken, rather than strengthen, Europe’s position.