Main ideas to be retained

• This new conflict changes the outlook for the euro zone, which showed solid momentum at the end of last year and inflation was 1.9% in February.
• The three pillars that will guide its decisions are: (1) the assessment of the nature and persistence of the energy shock, (2) a priority focus on risks and scenarios, and (3) the use of graduated options according to the severity of the situation.
• Lagarde aims to show that the eurozone is in a stronger starting position than during the Ukraine invasion, with inflation that has been close to target, expectations well anchored and monetary policy at neutral levels.

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Principles of the ECB Strategy

The ECB’s response is based on three strategic pillars:

• Shock assessment: Before deciding policy, the ECB must identify when energy costs risk leaking into headline inflation through indirect effects on wages and expectations.
• Focus on risks and not only on the baseline scenario: Since the effects of price shocks can be non-linear, the ECB works with scenarios and pays attention to forward-looking signals.
• Graduated options: ECB responses depend on the intensity and duration of the shock. Small and transitory supply shocks can be ignored, but large and persistent deviations from the inflation target require action.

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The current clash versus the one in 2022

Although the current environment is worrisome, there are notable differences from the 2022 energy crisis following the invasion of Ukraine:

• Magnitude of the shock: The current initial shock is smaller. Whereas in 2022 natural gas reached €340/MWh, it is currently around €60. However, oil prices are already hovering around $130 per barrel, comparable to the peak in March 2022.
• Macroeconomic environment: In 2022, the economy had strong post-pandemic pent-up demand and labor shortages. Today, the eurozone is in a moderate recovery without such pronounced imbalances, and inflation has been close to the 2% target for almost a year.
• Economic policies: In 2022, monetary policy was highly accommodative. Currently, interest rates and the fiscal stance are at mostly neutral levels.

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Risk scenarios analyzed

ECB staff have designed two scenarios under the assumption of no change in current policy:

• Adverse scenario: Assumes a sharp but short-lived shock. Inflation would rise by almost one percentage point this year compared to forecast, but would fall sharply by 2028.
• Severe scenario: Contemplates higher intensity, long duration and persistent propagation. Inflation would be significantly higher (almost three points higher in 2027) and would not return to target within the projection period, while growth would be significantly weakened in 2026 and 2027.

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Possible Monetary Policy Responses

Lagarde clarifies that the ECB is not paralyzed and has flexible options:

• Agility: They have abandoned the previous commitment to the rate path, preferring a data-dependent “meeting-by-meeting” approach.
• Action according to severity: If the shock is small and brief, it will be ignored. If there is a large but not persistent deviation, measured adjustments will be made. If a significant and persistent deviation is expected, the response will be directed at preventing inflation from becoming entrenched.