By David Barwick – FRANKFURT (Econostream) – European Central Bank Executive Board member Philip Lane on Friday said the Middle East conflict had forced the ECB to assess how higher energy prices would affect the Eurozone outlook, and warned that production networks could make such shocks more persistent than their initial impact suggested.

In a keynote speech at the Asian Monetary Policy Forum in Singapore, Lane said disruptions to shipping through the Strait of Hormuz, which accounts for around 20% of global oil supply, had led to a sharp rise in oil and gas prices and heightened uncertainty.

ECB modeling of the conflict included adverse and severe scenarios that differed according to the intensity of the energy supply disruption and the persistence of the price shock, Lane said.

In the adverse scenario, oil prices were assumed to peak at $119 per barrel and gas prices at €87 per megawatt-hour. In the severe scenario, oil was assumed to reach $145 per barrel and gas €106 per megawatt-hour, with much slower normalization.

The model was used to trace transmission from the initial supply disruption through commodity markets to output and inflation across major economies and to quantify the resulting drag on Eurozone foreign demand, he said.

The policy-relevant point, according to Lane, was not only the first-round effect of higher energy costs. He said production networks could transmit and magnify the inflation impact as higher costs feed into selling prices, export prices and import costs across borders.

“This feedback loop between selling prices and production costs amplifies and prolongs the inflationary episode well beyond the initial shock,” he said.

With national and international input-output linkages switched off, the cumulative headline inflation response was only around 60% of the baseline, Lane said. Put differently, the full production-network structure accounted for roughly 40% of the cumulative inflation response.

“These mechanisms are directly relevant to the current conjuncture,” he said.

The Middle East conflict had raised energy prices globally, but the impact on competitiveness was asymmetric, Lane said. China’s faster shift toward cheaper energy sources, including discounted Russian supply and renewables, meant the energy shock was raising input costs for European producers relative to Chinese competitors.

At the same time, Lane stopped short of drawing a mechanical monetary policy conclusion from a global supply shock.

A global supply shock that raises foreign inflation while reducing foreign output typically lifts Eurozone inflation and lowers GDP, he said. However, such responses were subject to considerable uncertainty.

“Consequently, the monetary policy response is not well identified,” he said.

A more granular identification strategy was therefore needed to determine the appropriate response, Lane said.

Foreign demand shocks were different, according to Lane. When foreign demand increases, Eurozone exports and activity benefit, the euro tends to depreciate in real effective terms, and higher demand pushes prices up.

“This combination of stronger output and higher inflation implies that euro area monetary policy needs to tighten,” he said.

Lane said monetary policy also could not respond mechanically to exchange rates or foreign interest rates.

“[M]onetary policy cannot respond to exchange rates or foreign interest rates as such; it must respond to their implications for the domestic inflation outlook, which depend on the nature of the shock driving them,” he said.

Relatively subdued import prices from China had helped contain Eurozone inflation, both directly through goods prices and indirectly by putting downward pressure on exporters in other countries, Lane said.

But China was also a source of vulnerability, including through its role in global commodity markets, critical raw materials and rare earths, he said.

Global shocks had accounted for more than half of movements in Eurozone interest rates in the last couple of years, Lane said, citing the role of global risk, energy, US monetary policy and US macroeconomic shocks.

In his conclusion, Lane said Asia mattered “substantially more” for the Eurozone than a decade ago and that Asian macroeconomic shocks now had spillovers to Eurozone GDP close to those of US shocks.

The monetary-policy implications of global shocks depended critically on the type of shock, he said.

Foreign demand shocks, supply shocks, monetary policy shocks and risk shocks could generate very different combinations of output, inflation and exchange-rate responses, Lane said.

Understanding the underlying drivers was essential to calibrate the appropriate monetary-policy response, he said.