By David Barwick – FRANKFURT (Econostream) – European Central Bank Governing Council member Olli Rehn said on Wednesday that the ECB should not base monetary policy on oil prices alone, but instead assess whether the energy shock spreads to inflation expectations, wages and underlying inflation.

In a speech at the LocalTapiola Asset Management Summit in Finland, Rehn, who heads the Bank of Finland, said the Middle East war had increased uncertainty, lifted energy prices, weakened confidence and tightened financing conditions.

“First of all, it is worth preparing for a protracted conflict in the Strait of Hormuz,” he said.

If events turned out differently, it would be easier to adjust, Rehn said.

Energy-price increases were slowing growth and pushing inflation higher in the short term, amounting to a stagflationary shock, he said.

Eurozone growth had been only slightly positive in the first quarter, while inflation had accelerated to 3% in April, Rehn said.

Developments since March had moved the Eurozone closer to the ECB’s more adverse scenario at least with respect to oil prices, while forward-looking indicators also pointed to weaker growth, he said.

Still, the current shock differed from the 2022 energy shock, Rehn said. Before the Iran war, inflation had been close to the ECB’s 2% target and the deposit rate was near neutral at 2%, while there was no strong fiscal stimulus, pent-up demand or pandemic-era production bottlenecks, he said.

The 2011 episode also offered a warning, Rehn said, noting that ECB rate hikes after the energy shock linked to the Arab Spring and Libya’s civil war had been reversed later that year as growth weakened and the debt crisis deepened.

That case could be seen as “a textbook example” of monetary policy reacting too strongly to higher energy prices while overlooking broader economic weakness, he said.

“Monetary policy should therefore not be built around a single price, such as oil,” he said. “The overall economic picture is decisive.”

For monetary policy, the key factors were the strength and duration of the energy shock and any broader pass-through into inflation, Rehn said.

Although Brent prices had risen clearly, the futures curve suggested markets were pricing in at least some normalization over time, he said.

Gas prices had also risen in Europe, but not nearly on the scale seen in 2022, and electricity prices had remained more moderate, he said.

“It can therefore be said that the energy shock is not, at least so far, quite comparable to the 2022 shock,” Rehn said.

For monetary policy, however, the decisive issue was whether higher prices affected expectations, wages and underlying inflation, he said.

Market-based medium-term inflation expectations remained anchored near the ECB’s 2% target, and professional forecasters were sending the same message, Rehn said. Consumer expectations had risen somewhat, he said.

There were risks, especially if the situation dragged on, Rehn said. The 2022 inflation surge was still fresh in people’s minds, and higher expectations could turn a temporary price spike into broader inflation pressure, he said.

Wage data were so far reassuring, with indicators still pointing to a gradual slowdown and no change yet visible in wage agreements reached since the outbreak of the Iran war, Rehn said.

Still, the ECB was paying particularly close attention to new wage deals concluded after the energy shock, he said.

By the ECB’s June meeting, policymakers would have updated projections and more information on inflation, underlying inflation and the Middle East situation, Rehn said.

The ECB was not committed to any interest-rate path and was not on a leash held by market expectations, he said.

“We make decisions meeting by meeting on the basis of the latest data and an overall assessment,” he said.

Rehn said the ECB’s decisions were guided in particular by the inflation outlook and related risks, underlying inflation dynamics and the strength of monetary policy transmission.

He outlined three broad policy options. If the price increase remained temporary, a central bank should generally avoid reacting strongly, because monetary policy worked with a lag and could worsen the economy, he said.

If the shock caused a large but temporary overshoot of the inflation target, policy might have to be tightened moderately to preserve credibility, he said.

If inflation were expected to deviate from target by a lot and for a long time, the central bank would have to react decisively and, if necessary, for an extended period, Rehn said.

“There is not yet sufficient certainty about how the situation will develop,” he said. “In any case, the objective is clear: the ECB Governing Council is committed to keeping inflation stable around 2% over the medium term, and monetary policy will be conducted with a steady hand also in this situation.”