The euro zone may already be moving along the European Central Bank's 'adverse' projection rather than its baseline, and inflation could become entrenched faster than during the 2022 episode, ECB policymaker Primoz Dolenc said in an interview.
Dolenc pointed to a recent jump in inflation above the ECB's 2% target, driven in part by higher energy costs linked to the war in Iran. The bank has signalled that it might need to raise interest rates if the current surge in energy prices begins to spread to a broader set of goods and services.
The ECB has set out alternative downside scenarios to its central forecast - labelled 'adverse' and 'severe' - each of which presumes higher and more persistent inflation alongside a larger drag on growth. "My personal impression is that baseline scenario appears to be more like a best-case scenario for the future and probably the current adverse scenario is more likely to be our next baseline," Dolenc said.
Dolenc warned that a worsening outlook driven by a protracted war risks influencing the behaviour of firms and households. That shift could push up price- and wage-setting, triggering so-called second-round effects that can make inflation self-sustaining - the ECB's principal concern.
"Second-round effects might not take as long to take hold as in our last inflation episode," Dolenc said. "People and firms have fresh memory of the inflation spike in 2022. And this is one of our biggest worries."
Financial markets currently price in between two and three ECB rate increases this year, with the first hike fully expected by June. Dolenc emphasised that the bank should avoid reacting to short-term price volatility, but must remain prepared to move quickly if evidence emerges that energy inflation is seeping into other sectors or if workers begin to incorporate higher inflation into wage demands.
"If there is a sign that higher energy prices will seep into other parts of the economy fairly quickly, and inflation expectations will rise quickly because of the memory effect, then we would need to consider acting sooner rather than later, in part to preserve our credibility," he said.
Dolenc noted that the ECB may not have a complete information set by its April 30 policy meeting. The central bank will, however, receive fresh data flows ahead of that date, including detailed March inflation statistics, updates from energy markets and various sentiment surveys, and will watch how the conflict evolves.
Some policymakers have indicated that a rate increase as early as April is an option. Bundesbank President Joachim Nagel has been cited as one such voice. Other officials, including ECB board member Isabel Schnabel and Cyprus central bank governor Christodoulos Patsalides, have cautioned against moving too hastily.
On the timing of any policy move, Dolenc said: "We cannot say today whether we’ll have enough information by April 30." He added that if the data remain insufficient, it would likely be appropriate to wait until the June meeting, when the ECB will have updated projections covering the next three years.
Still, he warned that if the conflict appears likely to persist and energy prices continue to transmit through the economy, lifting inflation expectations, the ECB might need to act as early as this month.
"We will not be simply driven by market expectations," Dolenc said. "But we will for sure do whatever we can to bring inflation down to our 2% target in the medium term."
The policymaker's remarks underscore the tightrope the ECB faces between waiting for confirmatory evidence and moving quickly to prevent temporary energy shocks from becoming entrenched inflation. The central bank's forthcoming meetings and the incoming sequence of data will be closely watched by markets, firms and households for signs that the bank will shift from a baseline posture to a more active tightening stance.
Context and near-term considerations
- Inflation has recently risen above the ECB's 2% goal, largely attributed to higher energy costs tied to the war in Iran.
- The ECB has prepared adverse and severe downside scenarios that assume higher, longer-lasting inflation and larger growth costs than the baseline.
- Policymakers will review comprehensive data before the April 30 meeting, but some may prefer to wait until the June projections if information remains incomplete.