By David Barwick – FRANKFURT (Econostream) – European Central Bank Governing Council member Olli Rehn said Tuesday that a rate increase next week would amount to insurance against inflation risks rather than a response to already entrenched price pressures.
Rehn, who heads the Bank of Finland, said in a speech that the war in Iran had created a stagflationary shock for the Eurozone, weakening growth prospects while pushing inflation higher in the short term.
“Against that backdrop, while inflation risks have increased, a rate increase in June would be an insurance one, but not due to entrenched inflationary pressures,” he said.
Developments appeared to be moving closer to an adverse scenario, especially through oil prices, though natural gas prices had risen less sharply, Rehn said.
The upcoming Eurosystem staff projections would provide “fresh data and a deeper assessment of the inflation and growth outlook,” he said.
Rehn said he saw three possible paths, the first of which was that the energy shock would prove temporary, with inflation rising for a period but the effect largely confined to energy prices before fading. In such a case, monetary policy should avoid overreacting, he said, but added that this path appeared “less and less likely, day-by-day.”
A second possibility was that inflation would rise more significantly and remain above target for longer, but without broad-based second-round effects through wages or profit margins, he said.
“In such circumstances, vigilance would be required, and the policy rate could, if deemed warranted, be increased as an insurance to ensure that inflation expectations stay anchored,” he said. “But it would not imply a start of a hiking cycle or lead to a more forceful monetary policy response.”
A more forceful response would be needed if the conflict became prolonged, energy prices stayed elevated and inflation pressures spread more broadly through the economy, he said.
“If we were to see convincing evidence that inflation expectations were becoming de-anchored and that wage-setting behavior was adjusting to persistently higher inflation, then monetary policy would need to respond decisively and quickly,” he said.
The case for tighter policy did not rest on higher oil prices alone, according to Rehn.
“What matters for monetary policy is whether the shock risks getting embedded in the inflationary process,” he said.
Market-based Eurozone inflation expectations remained anchored around the ECB’s 2% target at short- to medium-term horizons, he said, and had edged down modestly over the past week.
Still, the ECB’s inflation outlook remained challenging, with inflation projected at 3.5% this year in an adverse scenario, Rehn said.
Looking beyond monetary policy, Rehn said Europe faced a “triple test” involving defense, energy and productivity, requiring stronger joint defense investment, continued progress on the green transition and reforms to raise productivity growth.
“In this context, monetary policy will act with a steady hand and ensure price stability, thus supporting sustainable growth and job creation,” he said.