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(Bloomberg) — The European Central Bank 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 President Christine Lagarde.
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While 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 Wednesday in a speech.
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“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 paralyzed by hesitation: our commitment to delivering 2% inflation over the medium term is unconditional.”
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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 signaled borrowing costs may need to be lifted as soon as April if the price outlook sours further.
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“We are prepared, if appropriate, to make changes to our policy at any meeting,” Lagarde said.
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Lagarde laid out three cases on how the ECB should to the current situation.
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- “If the energy shock is seen to be limited in size and short-lived, the classical prescription of looking through should apply. Transmission lags mean that a monetary-policy response would arrive too late and risk being counterproductive.”
- “If the shock gives rise to a large though not-too-persistent overshoot of our target, some measured adjustment of policy could be warranted. The optimal response to such a deviation is smaller when the cause is exogenous supply disruptions rather than strong demand, but it is not necessarily zero.”
- “Moreover, to leave such an overshoot entirely unaddressed could pose a communication risk: the public may find it difficult to understand a reaction function that does not react.”
- “If we expect inflation to deviate significantly and persistently from target, the response must be appropriately forceful or persistent. Otherwise, self-reinforcing mechanisms would kick in and the risk of de-anchoring would become acute.”
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Inflation that had been at risk of undershooting 2% just a few weeks ago now looks set significantly surpass that target in the months ahead. Last week’s ECB’s baseline scenario foresees consumer prices advancing 2.6% this year. In an extreme outcome where disruptions to energy supplies persist, inflation would hit 6.3%.
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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.
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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.
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“It is essential to identify as early as possible when the shock is at risk of broadening,” she said, stressing the ECB’s “agility.”
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The signs at the moment aren’t good, with Lagarde cautioning that with attacks on the energy infrastructure in the Gulf region “the likelihood of a quick normalization is diminishing.”
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