ECB Monetary Policy Amid Shifts and Breaks. Navigating the 2026 Energy Shock

Even a relatively short-lived energy price spike would tell on prices and lead to a protracted period of monetary tightening. This is what experts of the European Parliament’s Economic Governance and EMU Scrutiny Unit predict as they compare the 2021-2022 and 2026 energy crises amid the current energy price growth caused by the Gulf war.

In standard New Keynesian models, which typically underpin many central banks’ forecasting, adverse supply shocks such as sharp increases in energy prices generate both higher inflation and weaker economic activity. Firms pass higher input costs on to prices, while real income losses compress demand. This creates a classic policy trade-off: stabilizing inflation requires monetary tightening, but this exacerbates the decline in output and employment.

Four years after an energy-driven inflationary outburst, the euro area is hit again by an energy shock, which could, if things develop unfavorably, result in a possible repetition of that past disaster.

Under present global value chains, even relatively short-lived energy price increases are likely to transmit to food prices and, directly or indirectly, to other price components. That would require a protracted phase of monetary tightening to bring inflation under control.

In the 2022 experience, the core and service components of the HICP index remained elevated long after the energy and food components had returned to ‘normal’. Downward price rigidity makes the lift of the generalized price level permanent, with consequences for the distribution of income that adversely affect the weaker segments of the population.

Earlier experience cannot tell us how intense the energy shock will be this time. The geopolitical context has changed in a fundamental way, hence the 2021-22 precedent cannot be applied to the present in any simple way. The chain of events this time will depend on how geopolitical factors play out.

Besides, the 2021-22 and 2026 situations differ. Energy prices, while sharply higher now than before the start of the war in Iran, are still below the levels touched in 2021 and early 2022, before the invasion of Ukraine and the international sanctions on Russian energy exports. In particular, gas prices have risen much less. By contrast, the prices of fertilizers – a key component of the agricultural value chains – have risen comparably.

Consumer prices in the first three months after this year’s shock have moved up in a way that is not materially different from the 2022 experience. Three months’ data are not definitive evidence but do call for heightened attention by the ECB, which, by its own admission, was late in reacting to the earlier inflationary phase.

The Harmonized Index of Consumer Prices (HICP) readings of March-April-May (flash) inflation, measured by the 12-month percent changes, were all rising and above target, which indicates that a monetary policy tightening is probably needed. The authors believe that the ECB would be well-advised to consider raising the interest rates.

However, calculations by the Munich-based Institute for Economic Research (Ifo) show that energy price growth would cause direct losses for the population, with each German losing some EUR 400. And no one has calculated the losses from interest rate increases and job cuts. Financial Times writes that while some countries, including Italy, Poland and Spain, have reduced their fuel taxes, the European Commission insists on restricting measures like energy subsidies and tax reductions.

Source: https://www.ceps.eu/ceps-publications/ecb-monetary-policy-amid-shifts-and-breaks/