Inflation forecast jumps as conflict weighs on economy

The Central Bank of Cyprus (CBC) on Friday revised down its forecasts for economic growth in 2026 and 2027, citing the continuing war in the Middle East and warning that risks remain skewed towards weaker growth and higher inflation.

Under its June 2026 projections, the central bank lowered its forecast for gross domestic product (GDP) growth in 2026 by 0.2 percentage points to 2.5 per cent and reduced its estimate for 2027 by 0.1 percentage points to 2.9 per cent compared with its projections published in March.

The CBC also now expects unemployment to rise by 0.1 percentage points to 4.6 per cent in 2026.

At the same time, it forecasts that inflation will surge by 0.5 percentage points to 3.2 per cent in 2026.

The central bank maintained its March forecast for core inflation, which excludes volatile energy and food prices, at 2.3 per cent for 2026.

In its projections for Cyprus’ main macroeconomic indicators covering the period from 2026 to 2028, the central bank said its baseline scenario assumes that the conflict will continue until the final quarter of 2026 before gradually easing.

“The probabilities of deviations from the baseline scenario for the period 2026-2028 are assessed overall as being tilted to the downside for GDP and to the upside for inflation,” the CBC said.

According to the central bank, the medium-term effects on the Cypriot economy will depend on the duration and intensity of the war.

“The June 2026 projections incorporate the economic impact of the ongoing war in the Middle East,” the CBC said.

“Because of the continuing conflict in the Middle East, the significant increase in international oil prices and geopolitical uncertainty are expected to have an immediate negative effect on the Cypriot economy, particularly on tourism, shipping, construction and the real estate sector, which depend heavily on inflows of foreign direct investment,” it added.

The central bank described the announcement of a US-Iran agreement as a positive development.

However, it stressed that the agreement has not yet been finalised or implemented and that key issues remain under negotiation.

“There is a risk of divergence if the commitments of both sides are not upheld and therefore the related risks to GDP and inflation remain,” the central bank said.

It added that these risks are linked to possible fuel shortages and the imposition of quotas stemming from severe disruptions to energy and raw material production if the war in the Middle East persists.

The central bank also warned of potentially higher-than-expected energy and import prices caused by supply chain problems.

Additional risks stem from climate change, including extreme weather events and green taxes, as well as from wage increases and profit margins rising beyond expectations.

The CBC now expects economic growth to slow to 2.5 per cent in 2026, compared with 3.8 per cent in 2025.

Moreover, growth is then projected to accelerate to 2.9 per cent in 2027 and 3.1 per cent in 2028.

Compared with the March 2026 projections, growth estimates were revised down by 0.2 percentage points and 0.1 percentage points for 2026 and 2027 respectively, mainly because of the continuing war in the Middle East.

“The relatively limited impact for 2026 compared with the March projections is attributed to the fact that some conservative estimates regarding the effects of the war had already been incorporated into the previous forecasting round,” the central bank said.

It added that the June projections assume a longer duration for the conflict.

According to the CBC, domestic demand between 2026 and 2028 is expected to be supported by continued growth in private consumption.

This is due to rising real disposable household incomes despite stronger inflationary pressures and the resilience shown by the labour market.

The central bank also expects substantial support for domestic demand from large ongoing private non-residential investments despite the pressures created by geopolitical uncertainty.

“Although their implementation timetable may be affected by the crisis in the Middle East, these projects are not expected to be cancelled, given the temporary nature of geopolitical instability and their long-term completion horizon,” it said.

The CBC also said the labour market continues to support the economy and remains highly resilient.

Unemployment is expected to rise slightly to 4.6 per cent in 2026 because of the negative effects of the Middle East crisis, although this impact is being moderated by tight labour market conditions.

For the period 2027-2028, unemployment is projected to stabilise at 4.5 per cent as GDP recovers.

Compared with the March projections, the unemployment rate for 2026 has been revised upwards by 0.1 percentage points due to lower growth expectations.

According to the central bank, inflation based on the Harmonised Index of Consumer Prices is forecast to rise sharply to 3.2 per cent in 2026 from 0.8 per cent in 2025.

The increase is mainly attributed to the economic consequences of the war in the Middle East.

The central bank expects significant upward pressure on energy prices due to higher international oil prices caused by restrictions on transit through the Strait of Hormuz.

These pressures are also expected to feed into other categories of inflation.

“Further upward effects are expected on the prices of industrial goods excluding energy, where disinflationary pressures are still being recorded, albeit smaller than those observed in 2025,” the CBC said.

It added that supply chain disruptions and increased production costs are contributing to these pressures.

Slightly higher natural gas prices compared with the previous year are also expected to push prices higher.

Food prices are likewise projected to come under upward pressure, mainly because of higher fertiliser prices resulting from supply chain disruptions.

Inflation is expected to decline to 1.9 per cent in both 2027 and 2028, the CBC added.

The central bank attributed this to the anticipated downward base effect in energy prices, together with a gradual slowing in services inflation and, to a lesser extent, food prices.

The inflation forecast for 2028 includes the impact on transport fuel prices arising from the planned introduction of the European Union’s expanded Emissions Trading System (ETS2).

Compared with the March 2026 projections, inflation for 2026 was revised upwards by 0.5 percentage points because of the economic consequences of the war.

“The downward revision for 2028 by 0.3 percentage points is due to lower expected energy inflation resulting from the declining trend in oil prices from 2027 onwards,” the central bank explained.

Regarding core inflation, the CBC expects it to rise to 2.3 per cent in 2026 from 1.9 per cent in 2025.

“This increase is due to the expected higher inflation in services and industrial goods, reflecting the indirect effects of higher energy inflation,” it said.

What is more, core inflation is then forecast to ease to 2.2 per cent in 2027 and 1.9 per cent in 2028.

According to the central bank, this reflects the expected gradual slowdown in services inflation, partly offset by the return of prices for industrial goods excluding energy to positive territory.

Compared with the March 2026 projections, core inflation for 2027 has been revised upwards by 0.2 percentage points due to the effects of the war in the Middle East.

No revisions were made to the core inflation forecasts for 2026 and 2028, the CBC concluded.