The war involving Iran has pushed Europe’s central bankers out of their comfort zone. Does this mean that a price shock similar to that of 2022 is imminent, when inflation surged to 10.6% after Russia’s attack on Ukraine, Handelsblatt asks. European Central Bank President Christine Lagarde has promised that she will not allow such a situation to happen again. The incoming ECB Vice-President, Boris Vujčić, says: “We have learned our lessons.”
But is the ECB truly better prepared than it was four years ago? At that time, it raised interest rates only after inflation had already spiralled out of control. There are certain similarities with the situation then, but also important differences, Handelsblatt notes.
1. The energy price shock
The ECB is once again facing a classic energy price shock, which is pushing up petrol and heating oil prices. At the end of February, a barrel of Brent crude (159 litres), the key benchmark for Europe, cost less than $70. Now prices are barely falling below $100. The impact on prices is broadly comparable to that of 2022.
Gas prices in March were on average around two-thirds higher than before the war with Iran. In 2022, however, gas prices rose far more sharply. Even so, empty gas storage facilities may again become a problem.
A war lasting several months would intensify the energy crisis. Dozens of power plants in the Gulf region have been damaged. Industrialised countries are already drawing on their oil reserves more heavily than they did in 2022.
The most important difference: when Russia invaded Ukraine in February 2022, inflation had already reached 4%. The energy price shock was an additional factor. This time, however, inflation has been close to the ECB’s 2% target for months.
Supply chains are not under the same pressure as during the coronavirus crisis. Freight costs are not rising as dramatically. However, isolated bottlenecks are emerging, triggering domino effects that affect prices in agriculture (fertilisers) and the semiconductor industry (helium).
With a few exceptions, the economy is performing worse than it did in 2022. The labour market remains stable but is not operating at full capacity. Consumers are not spending the savings accumulated during the pandemic. Government aid programmes that boosted demand and prices are available only in isolated cases.
For Christian Kopf of Union Investment, “there are several indications that rising energy prices will have a less pronounced impact on inflation this time.” Inflation rates of around 3–4% are indeed very high, says Deka chief economist Ulrich Kater, “but they are far from the horrors of inflation.”
2. The power of memory
“The memory of high inflation is still fresh,” Lagarde said on Wednesday. People are now more sensitive about their purchasing power. According to a study by consultancy Oxford Economics, consumers are searching online more frequently for the keyword “inflation”.
“The crucial question is not only whether energy prices will rise again,” says Ulrike Kastens of Deutsche Bank subsidiary DWS, “but also how long that increase remains in consumers’ minds.”
Trade unions could once again demand wage adjustments linked to inflation, encouraged by the unusually strong wage settlements of recent years. Despite the economic slowdown, companies are not hesitating to pass on higher costs. According to purchasing managers’ surveys, selling prices reached a three-year high in March.
These secondary effects are precisely what Europe’s central bankers fear. They could ensure that the energy crisis does not remain a one-off price shock. Inflation could then spread more deeply into other sectors of the economy and become entrenched.
For Isabel Schnabel, a member of the ECB Executive Board, this is the main lesson from 2022: an energy price shock can affect consumer prices “faster than we previously believed”. “We now know this,” Schnabel said on Friday evening at the University of Zurich.
Experts are nevertheless surprised that the ECB is already factoring in significant secondary effects, which usually take time to appear. According to Morgan Stanley, the central bank’s economists evidently wanted to protect themselves early from forecasting errors. “The trauma of 2022 is still having an impact,” says Friedrich Heinemann of the ZEW economic research institute.
3. The inflation shock becomes an interest rate shock
When the ECB raised interest rates in the summer of 2022, inflation was already close to 9%. Core inflation, excluding energy, stood at 4%. The inflation shock culminated in an interest rate shock: the ECB rapidly raised the deposit rate for banks – the benchmark for savings and loan interest rates – to as high as 4%, in some cases through large increases.
ECB economists underestimated the severity of inflation, but their delayed reaction cannot be explained solely by incorrect forecasts. Their communication also played a role. The ECB had signalled to markets that under all circumstances it would first stop bond purchases and only then raise interest rates.
At that time, it was common practice to set monetary policy months in advance. After years of chronically low inflation, markets and central bankers had become accustomed to negative interest rates and trillions of dollars in bond purchases. They had lost a sense of how quickly the situation could change once inflation returned.
The situation is different today. The ECB is gradually and automatically reducing its massive bond holdings. This already makes monetary policy tighter, even if only slightly noticeable. The key interest rate has been at a neutral level of 2% for nine months, neither slowing nor stimulating the economy. Central bankers emphasise with notable frequency that they are starting from a stronger position this time.
4. A new strategy
“Lessons learned”: under this heading, the ECB has reformed its strategy. Central bankers no longer commit in advance to a specific course of action, but instead want to assess the situation based on new data at every meeting. This is the message of ECB chief economist Philip Lane.
Central bankers have abandoned their previous “wait and see” approach. They now intend to react more decisively to supply shocks such as the current energy crisis. While the ECB cannot directly influence oil and gas prices – since monetary policy primarily affects borrowing and lending costs – it now considers such crises a systematic source of inflation.
The basic idea is this: if price pressures become entrenched, the central bank will intervene earlier. If supply shocks prove not to be short-lived, a monetary policy response will be necessary, said ECB Vice-President-designate Vujčić.
The central bank is addressing the high degree of uncertainty caused by such shocks through economic scenarios. In this way, it aims to be prepared for unexpected developments. The days when the ECB relied on a single forecast or simply on intuition are supposed to be over. It has also comprehensively revised its forecasting models.
5. Fast up, fast down
In practical terms, the strategic reform could lead to an interest rate increase as early as the end of April. Bundesbank President Joachim Nagel considers this “an option”, while Belgium’s central bank governor Pierre Wunsch says it “cannot be ruled out”.
At the top of the ECB, however, the prevailing message is clearly to remain as vague as possible and avoid public speculation about a timetable. Schnabel dampened interest rate speculation on Friday: the ECB must remain “flexible” and “alert”, “but there is no reason to rush”.
In reality, many experts believe the ECB faces a dilemma. It must balance interest rate increases against the economic slowdown. Otherwise, central bankers risk choking off fragile growth.
For Frederik Ducrozet of asset manager Pictet, the current situation is “completely different” from four years ago. “An interest rate increase would be another mistake and would only make things worse,” he says. Vujčić counters this assessment, arguing that one or two rate increases would not significantly harm the economy.
“Inflation risks are the ECB’s main concern and are given greater weight,” says Alessandro Tentori, a market specialist at BNP Paribas. “An excessive reaction from the ECB would be just as harmful as no reaction. Excessively high inflation is problematic – but so is excessively low inflation.”
For the ECB, the solution could be to raise key interest rates only temporarily. Evelyn Herrmann of Bank of America considers an April rate increase premature, but the threshold for tighter monetary policy now appears lower than previously estimated. “However, we expect rate cuts to follow in 2027.”
Morgan Stanley analysts predict that weaker growth compared with 2022 will lead the ECB to only a small rate increase, followed by cuts in 2027. Meanwhile, Goldman Sachs economist Jari Stehn links his revised forecast for rate increases in April and July to the expectation that the ECB will reverse them the following year.
Source: newmoney.gr