SOFIA, April 7 - Euro area inflation expectations risk moving upward more rapidly than in past episodes, and the European Central Bank must be prepared to tighten policy quickly if signs of sustained price pressures materialise, said Dimitar Radev.
Radev, who leads Bulgaria's central bank and is one of the newest members of the ECB's Governing Council, pointed to a surge in energy costs linked to the Iran war as a factor that has already pushed inflation well above the ECB's 2% objective. Policymakers are debating whether to raise interest rates to prevent this energy-driven rise from becoming embedded across other prices and wages, potentially triggering a self-reinforcing inflation cycle.
The shifting balance of risks
"The balance of risks has shifted in an unfavourable direction," Radev said. He noted that, while the baseline scenario remains the reference point, the probability of a more adverse outcome has increased, "particularly in light of the energy shock and the elevated level of uncertainty," referring to the three scenarios - adverse, baseline and severe - the ECB outlined last month.
A central concern is that households and businesses, having lived through a period of runaway prices only four years ago after Russia's invasion of Ukraine, could rapidly update their price and wage expectations. If they do, this behavioural shift could lead firms to raise prices and workers to demand higher pay, initiating a cycle that becomes costly to break.
Behavioural responsiveness and recent data
Radev warned that recent inflation developments have made expectations more reactive. "Recent inflation developments appear to have increased the responsiveness of expectations, meaning that pass-through from new shocks can occur more quickly than under normal conditions," he said. This view aligns with similar cautions from other policymakers who have urged readiness to act, even if they have not explicitly called for immediate rate hikes.
For now, inflation expectations remain at the ECB's target and second-round effects are not evident in available data. The March inflation reading, for example, recorded a sharp increase driven by energy but showed signs that price pressures in services were easing. Despite these signs, Radev stressed that the situation cannot be assumed to remain benign because the current environment is fragile and capable of rapid change.
The case for timely action
"If the shock persists and begins to affect wages, margins and expectations, the cost of inaction would increase," Radev said. "In such a situation, acting in a timely manner would be the more prudent course." This potential for faster feedback loops between shocks and expectations is a core reason why financial markets have priced in more than two interest rate increases from the ECB this year, with the first hike currently expected in June.
Radev commented that it was too early to judge whether the ECB would have sufficient information by the April 30 meeting to make a decisive policy call, but he added that the bank should have enough data to support a more structured and concrete policy discussion at that time. He said the ECB will pay particular attention to a range of indicators, including various measures of inflation expectations, underlying price trends, sentiment gauges, developments in energy prices and, notably, indicators about the likely duration of the Iran war and its economic effects.
Starting position and fiscal risks
Although the 2022 episode may have made agents more sensitive to price shocks, Radev also acknowledged a structural difference this time: the euro zone is entering the current shock from a stronger position because interest rates are already higher and inflation expectations remain anchored. Nonetheless, he highlighted a clear fiscal risk: government support measures. "The big risk now is that governments start implementing subsidies that could potentially add fuel to the fire," he said, warning that such measures could amplify price pressures.
Radev's remarks underscore the delicate trade-offs facing the ECB as it balances the need to prevent temporary shocks from morphing into persistent inflation against the costs of premature tightening. The bank's decisions over coming weeks will be guided by evolving data on prices, expectations and energy markets.
Key readouts for markets and policymakers
- Monitoring of inflation expectations and underlying price measures will be central to the ECB's policy deliberations.
- Energy price trajectories and signals about the length of the Iran conflict will be treated as high-impact inputs to policy assessment.
- Financial markets are already pricing in a material chance of further rate increases this year, reflecting elevated concern about a potential shift in expectations.