The European Central Bank (ECB) will act decisively and swiftly if the current surge in energy costs risks a broader bout of inflation, though for now it’s still assessing the shock caused by the Iran war, according to its president Christine Lagarde.
Although the situation is different from 2022, when Russia’s invasion of Ukraine ultimately sent consumer-price growth into double digits, there are “reasons for vigilance,” Lagarde said in a speech on Wednesday.
“We will not act before we have sufficient information on the size and persistence of the shock and its propagation,” she told the ECB Watchers Conference in Frankfurt. “But we will not be paralysed by hesitation: our commitment to delivering 2 per cent inflation over the medium term is unconditional.”
Soaring energy costs brought on by the conflict in the Middle East are stoking fears of another inflation spike like the one four years ago. Bundesbank chief Joachim Nagel and others have signalled borrowing costs may need to be lifted as soon as April if the price outlook sours further.
“We are prepared, if appropriate, to make changes to our policy at any meeting,” Lagarde said.
Lagarde laid out three cases on how the ECB should respond to the current situation:
- “If the energy shock is seen to be limited in size and short-lived, the classical prescription of looking through should apply.”
- “If the shock gives rise to a large though not-too-persistent overshoot of our target, some measured adjustment of policy could be warranted.”
- “If we expect inflation to deviate significantly and persistently from target, the response must be appropriately forceful or persistent.”
Inflation that had been at risk of undershooting 2 per cent just a few weeks ago now looks set to significantly surpass that target in the months ahead. Last week’s ECB’s baseline scenario foresees consumer prices advancing 2.6 per cent this year. In an extreme outcome where disruptions to energy supplies persist, inflation would hit 6.3 per cent.
Costlier oil and gas could also derail Europe’s economy. Data on Tuesday showed private-sector activity in the currency bloc rising at the slowest pace since last May.
Lagarde said historical evidence suggests the risk of broad pass-through from energy prices “is the exception rather than the rule” in the euro area. But that picture may change due to the intensity and duration of the shock as well as its propagation, which depends on the macroeconomic environment.
“It is essential to identify as early as possible when the shock is at risk of broadening,” she said, stressing the ECB’s “agility.”
The signs at the moment are not good, with Lagarde cautioning that with attacks on the energy infrastructure in the Gulf region “the likelihood of a quick normalisation is diminishing.”
That could mean firms and workers react faster this time than four years ago, when the ECB was heavily criticised for underestimating the dangers and acting even later than many peers.
Nagel told Bloomberg last week that the 2022 experience “will play an important role” – even if the ECB finds itself in a better starting position today, with inflation significantly lower and policy settings neutral rather than accommodative.
“We have a more recent memory of high inflation, which could affect how quickly costs are passed on and compensation is sought,” Lagarde said. “We are prepared, if appropriate, to make changes to our policy at any meeting.” – Bloomberg
