Amid escalating tensions in the Middle East, surging energy costs have reignited concerns about inflation. European Central Bank President Lagarde made it clear that hesitation will not be allowed to delay necessary action. Should price pressures persist, the ECB could adjust its policy as early as April.
European Central Bank President Christine Lagarde said on Wednesday at the 'ECB Watchers Conference' in Frankfurt that if the current surge in energy costs triggers broader inflation risks, the ECB will take decisive and swift action. Although the ECB is still assessing the impact of the conflict in Iran, Lagarde emphasized that policymakers will not repeat past mistakes.
Although the current situation differs from the double-digit inflation triggered by the Russia-Ukraine conflict in 2022, Lagarde believes that 'vigilance' remains the key term for now.
‘Before we have sufficient information about the scale, persistence, and transmission mechanisms of the shock, we will not act rashly,’ Lagarde pointed out. ‘But we will never fall into “action paralysis” due to indecision. Our commitment to returning medium-term inflation to the 2% target is unconditional.’
The sharp volatility in energy prices triggered by the Middle East conflict has raised market concerns about a replay of the inflation nightmare from four years ago. Officials such as Joachim Nagel, President of the Bundesbank, have signaled that if the price outlook deteriorates further, the ECB may raise borrowing costs as early as April.
In her speech, Lagarde outlined three logical frameworks for addressing the current situation:
Short-term limited shock: If energy price fluctuations prove to be limited in scale and short-lived, the ECB's traditional approach is to ‘look the other way,’ meaning no intervention. This is because monetary policy has a lag effect, and intervening at this point could backfire.
Moderate and unexpected inflation: If the shock causes inflation to deviate significantly from the target but is not expected to last long, a ‘moderate’ policy adjustment may be necessary. Since this is caused by external supply disruptions rather than excessive demand, the policy response does not need to be overly aggressive but should not be ‘zero action’ either. Lagarde pointed out that completely ignoring this could pose communication risks, leading to public doubts about the central bank’s response mechanism.
Significant and persistent deviation: If inflation deviates from the target in both degree and duration beyond expectations, the ECB must adopt strong and sustained measures; otherwise, it risks triggering a ‘self-reinforcing mechanism’ and ‘expectation de-anchoring.’
Just a few weeks ago, markets were concerned that inflation might fall below the 2% target, but the situation has now completely reversed. The ECB’s baseline forecast last week showed consumer prices are expected to rise by 2.6% this year. In an extreme scenario of prolonged energy supply disruptions, inflation could even soar to 6.3%.
High energy costs not only push up prices but could also severely impact the European economy. Data released on Tuesday this week showed that the growth rate of private sector activity in the eurozone had dropped to its lowest level since May of last year.
Lagarde admitted that, based on historical experience, the large-scale transmission of energy prices to overall prices in the Eurozone has been 'the exception rather than the rule.' However, this pattern may change due to the intensity, duration of the shock, and the current macroeconomic environment. She emphasized that the European Central Bank (ECB) must remain 'agile' and identify risks of shock diffusion as early as possible.
The current signs are not optimistic. Lagarde warned that the possibility of a 'rapid normalization' of the situation is diminishing as energy infrastructure in the Gulf region comes under attack. This means businesses and workers may react to price increases faster this time than they did four years ago — when the ECB was heavily criticized for underestimating inflation risks and responding more slowly than other central banks.
Last week, Bundesbank President Nagel also stated that the lessons from 2022 will play an important role. Despite the currently lower inflation rate and monetary policy already being in a neutral rather than accommodative range, the situation remains severe.
Lagarde concluded by saying, 'The memory of high inflation has not faded, which will accelerate cost transmission and compensatory demands. Therefore, we are prepared to adjust policies at any meeting if necessary.'
Editor/Doris