Europe is at a familiar crossroads. An energy shock, smaller than in 2022 and this time rooted in the Middle East war, is weighing on growth and pushing inflation higher. Prior to the war, our forecast would have been upgraded. Now we see growth slowing down. Initial data point already to weaker private investment and consumption. The outlook for euro area growth is projected at just 1.1 percent in 2026, for the European Union it is 1.3 percent; and this forecast comes with a high degree of uncertainty. In a more severe scenario as described in the World Economic Outlook—a persistent supply shock compounded by tightening financial conditions—the EU could come close to recession with inflation approaching 5 percent. No European country is spared.
Policymakers face intense pressure—to act fast, visibly, and for all. Often, as examples below will show, this results in policies that have more long-term downsides than short-term benefits. Targeted support is much more effective. Europe's response to this shock should be shaped by two imperatives. First, robust macroeconomic policy that is fit for a world with unpredictable and frequent shocks, and second, resilience built without wasting fiscal resources or getting in the way of markets.
Fiscal and monetary
The first imperative involves getting monetary and fiscal policy right.
Central banks must remain laser focused on keeping inflation expectations anchored. The post-COVID inflation shock is a reminder of the importance of monitoring second round price effects. In the euro area, where inflation is close to target and medium-term expectations are broadly anchored, the European Central Bank has some scope to wait and observe the shock evolve before acting. We currently expect a cumulative 50 basis point increase in the policy rate by the end of this year, maintaining a broadly neutral monetary stance in light of higher near-term inflation expectations. The desired response could be less or more than that depending on the developments in global energy markets in the coming weeks, as well as in the euro area economy, which will shape the strength of any second-round effects.
A rise in core inflation, which excludes more volatile food and energy components, or increasing medium-term expectations would warrant a more restrictive stance. In the United Kingdom, where inflation risks remain elevated, a restrictive stance should be maintained to prevent energy price pressures from becoming entrenched in wages and prices. This suggests limited scope for further rate cuts in 2026. In several Central, Eastern, and Southeastern European economies, where inflation is still above target and wage growth remains strong, the case for a more restrictive stance is already building.
Financial stability warrants close attention too. In a severe scenario, stress in credit markets could spread quickly. Authorities should monitor vulnerabilities in both bank and nonbank sectors, stand ready to release capital buffers if systemic risks materialize, and ensure liquidity support is available to eligible institutions that need it.
Fiscal policy must do its part—but it has to work within the available fiscal space. High-debt countries without fiscal space cannot afford to widen deficits: any energy-related measures must be fully offset so as not to add to already stretched public finances in a more difficult market environment.
Some countries have more room to absorb the shock and support their economies, but even they face rising pressures from defense, aging, and the energy transition. For instance, countries like Denmark or Sweden with comparatively low debt have the space for counter cyclical fiscal policies, while France and Italy do not.
The fiscal path has implications for investor confidence: sovereign yields have already risen in several markets, and high-debt countries need to stick to their consolidation plans to keep borrowing costs anchored and preserve the capacity to respond if conditions deteriorate further.
Targeted and time-bound support
When energy prices rise and people and businesses feel the pain, policymakers feel pressure to act. The temptation is to simply stop prices from rising, using price caps, universal rebates, or fuel tax cuts. These are unwise measures.
Untargeted support disproportionately benefits higher-income households, who consume more energy. During the 2022 crisis, European governments spent an average of 2.5 percent of gross domestic product on energy support packages—more than two-thirds untargeted. IMF analysis shows that fully compensating the bottom 40 percent of households for the entire rise in energy costs would have required just 0.9 percent of GDP.
The fiscal cost is only part of the problem. Broad support also suppresses the price signal—the market incentive that drives people and businesses to reduce consumption, improve efficiency, and invest in alternatives. When that signal is muted, the adjustment that ultimately resolves a supply shock is slowed. Moreover, governments that heavily suppressed price signals in 2022 found themselves sustaining expensive measures long after the emergency had passed, with less efficient energy use to show for it. Germany's approach—cushioning the shock without eliminating the price signal—produced better outcomes on both counts.
As countries plan their responses, they should not repeat the same costly mistakes. Broad and open-ended support measures are hard to unwind and should be avoided.
Announcing binding end dates of targeted measures will ensure that budget resources are not wasted and don’t crowd out investments needed to strengthen Europe’s energy system and reduce its vulnerability to future shocks.
Building resilience
The second imperative is to build resilience. This is even harder to implement politically. But the evidence for it is unambiguous.
Industrial energy prices in the EU are now roughly double their pre-2022 levels and substantially higher than those in the US, a chronic disadvantage rooted in imported oil and gas dependence and fragmented energy markets. The good news is that the solution is already emerging. More than 50 percent of EU electricity generation now comes from low-carbon sources, measurably reducing exposure to oil price swings. Completing the energy single market, maintaining the EU’s Emissions Trading System, and accelerating cross-border grid interconnection are not abstract goals—they are the path to structurally lower and more stable energy costs.
The benefits of the broader reform agenda are equally compelling. IMF analysis suggests that fully closing domestic structural policy gaps and integrating labor and product markets to the levels observed within the US could raise European productivity by 20 percent, mobilizing up to €800 billion in additional private investment over ten years. As a result, output per person would be higher by 35 percentage points. Such gains illustrate that closing the income gap with the US can be achieved by reforms in areas that are firmly under Europe’s control. Tackling them would build durable gains in living standards and create much-needed buffers to adverse shocks. They would also deepen financial integration and raise Europe’s shock absorption capacity further.
Europe’s choice is not between helping people now and reforming later. It is between costly measures that don’t actually reduce vulnerabilities; and policies that instead protect the most exposed today while building the foundations for a more resilient tomorrow.
Reforms cannot wait
Crises create pressure to defer hard choices. Europe has succumbed to that temptation before. Postponing reforms risks slower growth, higher debt, and diminished capacity to act when the next shock arrives. In a world where shocks are becoming more frequent and overlapping — geopolitical disruptions, climate events, financial volatility — the capacity to respond is itself a strategic asset. It is built through sound macroeconomic management, disciplined fiscal policy, and structural reforms that reduce underlying vulnerabilities, particularly to energy price shocks. Especially now, Europe must stay the course on its energy sector transformation, raise the share of renewables while integrating the energy sector across Europe.
Europe must reform under pressure. The current shock is not an argument for delay. It is all the more reason to push forward the reform agenda.
