By David Barwick – FRANKFURT (Econostream) – European Central Bank Executive Board member Philip Lane on Wednesday said an energy-driven inflation overshoot that proved material and persistent could require a monetary policy response, while saying current evidence still showed limited broader effects from the Middle East shock.

In remarks at the Centre for European Reform in London, Lane said the current energy disruption was more global than the 2022 shock triggered by Russia’s invasion of Ukraine, and that such shocks could have stronger indirect inflation effects than regional shocks.

A supply-driven rise in oil prices was more damaging for an oil-importing economy such as the Eurozone than a demand-driven price increase, because it raised costs, reduced real household income, weakened global demand and increased uncertainty, Lane said.

ECB staff estimates suggested that a geopolitical oil supply shock lifting the real oil price by 10% would reduce Eurozone real GDP growth by about 0.2 to 0.3 percentage points in each of the first three years after the shock, he said.

The effect on investment was stronger than on consumption, consistent with investment being more exposed to uncertainty from geopolitical oil disruptions, he said.

Lane said the current energy disruption was more global than the 2022 shock triggered by Russia’s invasion of Ukraine, which was more regional and more Europe-centered.

“Compared with a regional shock, a global shock not only directly raises the price of imported energy but also indirectly raises the price of all energy-intensive imported goods,” he said. “This leads to a larger increase in overall import prices and thereby generates a more pronounced deterioration in the terms of trade.”

In ECB staff simulations, a global energy shock produced larger indirect effects on inflation than a regional shock of the same initial size, he said.

For a global shock, the non-energy component contributed around 1.5 percentage points cumulatively to total inflation, compared with about 0.4 percentage points for a regional shock, Lane said.

The global shock also did more harm to output than a regional shock, partly because weaker global demand reduced Eurozone net exports, he said.

Assessing the present shock required close monitoring of indirect effects and second-round effects, Lane said.

Indirect effects came as higher energy and transport costs moved through supply chains into non-energy goods and services, while second-round effects occurred when the shock affected wages, firms’ price and margin decisions, and inflation expectations, he said.

Current indicators suggested that the inflation impact had so far remained relatively contained, Lane said.

“The increase in selling price expectations in recent firm surveys suggest that the input cost pressures will map into higher output prices in the coming months at least in some sectors but the scale and breadth of the price increases remains uncertain,” he said.

Wage data were more reassuring, Lane said. Agreements reached since the outbreak of the Middle East war still signaled easing wage pressure and did not yet show a reaction to the rise in energy prices, he said.

The current shock was unfolding in a less demand-supportive environment than in 2022, Lane said, citing firm-side and news-based indicators.

At the same time, the shock was more global in nature and followed soon after the 2021-2022 inflation surge, he said.

That could make households and firms more attentive to inflation and mean that, even if propagation was more contained than in 2022, it could still be stronger and faster than historical averages, Lane said.

Scenario analysis would be essential in assessing possible medium-term outcomes, he said.

Just as the ECB’s March projection exercise had included adverse and severe scenarios alongside the baseline, scenario analysis would also be an intrinsic part of the June projection round, Lane said.

On monetary policy, Lane said an adverse energy supply shock differed from a domestic demand shock.

Higher energy prices reduced activity in energy-using sectors, lowered real household income and firms’ profits, increased uncertainty and could tighten financial conditions, all of which worked against medium-term inflation pressures, he said.

“All else equal, these ‘demand destruction’ channels limit the required adjustment in the monetary stance to ensure the timely return of inflation to the target,” he said.

Fiscal support would point in the other direction if it offset this demand weakening, because it could then require a larger monetary policy response, he said.

Lane said: “It is straightforward that small inflation deviations that are not expected to persist do not call for a monetary policy response.” Lags would make a response in this case “counterproductive,” he said.

He continued: “However, a sufficiently material and persistent deviation from the target requires a monetary policy response: a mid-size but not-too-persistent overshoot could warrant some measured adjustment of the policy stance, while if the inflation shock is expected to be larger and more persistent, the response must be appropriately forceful or persistent.”

Even for an exogenous supply disruption, an active response could be needed, Lane said.

He pointed to four possible channels: cost-of-living effects on later wage and price setting, lower real interest rates if elevated inflation was expected to last, extrapolation in inflation expectations, and the communication risk from failing to respond to a material inflation deviation.

A non-response to such a deviation could make the ECB’s reaction function harder for markets, firms and households to understand, increasing volatility in expectations for inflation and policy rates, Lane said.

The appropriate policy response was therefore nonlinear, he said. Mid-sized deviations could require incremental tightening, while large deviations could call for a more forceful or more persistent response.

Determining the appropriate stance under such conditions was a “judgment call,” especially in an uncertain environment, Lane said.

That decision should be made meeting by meeting and depend on incoming evidence about the shock, signs that relative price changes were becoming broader inflation dynamics, and the strength of the demand-weakening channels, he said.

The ECB’s rate decisions would remain based on the inflation outlook, the risks around it, underlying inflation dynamics and the strength of monetary policy transmission, with no pre-commitment to a particular rate path, Lane said.