ECB: In the “good place” no more, but in a different one than 2022

The ECB is no longer “in a good place.” Only weeks ago, euro area inflation was seemingly on track toward the ECB’s 2% policy target. But now, the ECB is grappling with how the conflict in the Middle East and its impact on energy prices and supply chains could raise the risk of higher inflation and slower economic growth, or stagflation. Yet they are in a different starting point now than back in 2022, “well-positioned and well-equipped” to deal with any potential rebound in inflation according to ECB President Christine Lagarde. Notwithstanding elevated uncertainty, there is for now limited urgency to act pre-emptively given where interest rates are today, economic growth near its long-term trend, and inflation expectations well-anchored at 2% before the conflict started.

Lagarde did not push back against market pricing that swung from weighing slim chances of a rate cut to pricing in at least one 25-basis point hike. But she did not signal imminent hikes either. Deciding to keep all options open stresses the uncertainty ahead, as do the “alternative” macro projections presented. Key to watch? Whether the energy shock spills over into broader inflation pressure. Policymakers can look through a temporary spike in energy prices. But any sustained rise in wages or inflation expectations would force a response. How “stagflationary” any supply shock proves depends on how long the conflict lasts and how much it disrupts supply chains. It would also add to existing inflation pressure from Europe’s shrinking workforce and slightly looser fiscal policy.