ECB’s Lane: Judgement Should Determine How to React to Mid-Size Inflation Deviations

3 December 2025

By Marta Vilar – MADRID (Econostream) – European Central Bank Chief Economist Philip Lane said on Wednesday that policymakers should rely on judgement when deciding whether to respond to a mid-size deviation of inflation from target.

In a speech at the 15th workshop on exchange rates, co-organized by Banka Slovenije in Ljubljana, Lane said that small inflation deviations expected to be short-lived did not warrant any monetary policy action.

“Most obviously, lags in the transmission of monetary policy mean that it would be counterproductive to seek to respond to near-term deviations that are solidly expected to be transitory,” he said.

Conversely, Lane argued that “a sufficiently large and persistent” inflation deviation should prompt a monetary policy response, regardless of its underlying cause.

Lane outlined the channels through which inflation could become self-reinforcing once it moved away from the ECB’s 2% target. Current inflation, he noted, influenced wage- and price-setting behavior, while persistent deviations affected real interest rates by altering the relationship between nominal rates and expected inflation.

He added that extended periods of inflation above or below target can influence how people form medium-term expectations, while a lack of policy response to a material deviation risked confusing markets about the ECB’s reaction function.

“Given these mechanisms, a material deviation of inflation from the target calls for a monetary policy response,” he said. He added that because these forces can operate in a non-linear way, the policy reaction should also be non-linear, involving “incremental adjustments to mid-sized deviations but a more forceful or persistent adjustment to large deviations.”

For mid-sized, moderately persistent deviations, understanding whether the under- or overshoot stemmed from demand or supply factors would be key to determining the right policy response, he said.

“In particular, an intermediate-category broad-based inflation deviation likely calls for an incremental adjustment in the monetary stance … However, if the origin of the inflation deviation is a supply-driven relative price level shock, the case for an active monetary policy response is more nuanced,” he said.

A mid-size energy price shock would not pose the same risks to the medium-term outlook for inflation as a domestic demand shock, he said, noting that the former might leave underlying inflation largely unaffected, despite its impact on headline inflation, and could even contain a self-correcting dynamic.

The ECB therefore needed to keep a close watch on both the actual and expected evolution of supplementary inflation indicators, including non-energy inflation and core inflation, he said.

“Clearly, it is a judgement call to determine how to respond to intermediate-category inflation deviations,” he said, adding that such decisions should be taken on a meeting-by-meeting, data-dependent basis within a comprehensive and rigorous analytical framework.

This required tracking and modelling the current and anticipated paths of wages, profit margins, underlying inflation measures and inflation expectations, he said, adding that this would help determine whether a moderate deviation risked becoming larger or more prolonged.

Lane also touched on exchange rate developments, noting that the euro showed no sustained trend over time and that currency movements generally tended to reverse as time passed.

He said ECB simulations showed that a 10% appreciation of the euro would have a sizeable and prolonged impact on the economy, lowering inflation for roughly three years and producing a peak disinflationary effect of 0.6 percentage points after about one year.

GDP would also be hit, declining throughout the adjustment period, with a total loss of around 1% after three years, he said.

Trade flows would weaken as well, he said, noting that a stronger euro would reduce export volumes by about 3% over the three-year horizon, while import volumes would fall by roughly 1.5%.

As for the impact of the exchange rate on financial conditions, Lane said that prior to the global financial crisis, a stronger euro helped tighten financial conditions in the euro area.

During the euro area debt crisis and the years that followed, the currency’s weakness complemented the ECB’s broadly accommodative stance by helping to ease overall financial conditions, he said.

“Most recently in 2025, the euro has recorded its strongest tightening impulse on the ‘Macro-Finance’ financial conditions index (MF-FCI), partly explained by the relative weakening of the US dollar,” he said.