The ECB’s Fragile Advantage
Temporary inflation is still possible, but only if governments resist subsidies and energy shocks fade quickly. A commentary by Lorenzo Bini Smaghi
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At the press conference following the latest meeting of the European Central Bank’s Governing Council, Christine Lagarde delivered one reassuring message, and another that was rather less so.
Starting with the reassuring — and persuasive — message: the central bank is now better “positioned” and better “equipped” than it was in 2022 to cope with a renewed inflation spike, for several reasons.
First of all, the starting point is different. The current energy shock is taking place when the interest rates set by the central bank are around 2 per cent.
In 2022, by contrast, the ECB started from negative rates. That required a drastic and very rapid adjustment in interest rates to bring the situation back under control.
One might add, as a further difference, that four years ago the ECB was still purchasing government bonds while inflation was rising, which required a sudden — and perhaps belated — change of course. At present, the central bank’s balance sheet is shrinking, which avoids fuelling inflationary pressures through additional liquidity.
Lagarde also underlined that the labour market is currently less tight than it was in 2022, reducing the risk of a wage-price spiral.
Finally, the rise in imported inflation is not currently being supported by an increase in aggregate demand, as happened in 2022 as a result of the drawdown of savings accumulated during the Covid period.
In short, there is now a greater chance that inflation will be driven mainly by supply-side factors and will therefore prove temporary in nature.
The central bank might avoid tightening monetary conditions excessively and instead wait for imported commodity prices to return to their initial levels, which would bring inflation back to the desired level — around 2 per cent — within an acceptable timeframe.
This benign scenario, however, depends on a number of conditions.
The first is that no fiscal measures should be adopted to support demand in ways that, as in 2022, would make inflationary effects more persistent. President Lagarde called on governments to restrain any compensatory action on prices, which should be “temporary, targeted and tailored”.
A second issue, which received less attention, concerns the risk of a tightening in financial conditions in the coming months. At the press conference, the ECB recalled that in January 2026 — that is, before the war with Iran started — credit to companies had increased by 2.8 per cent compared with the previous year. That may sound reassuring, but it is effectively zero when measured against nominal GDP growth.
Moreover, in the face of geopolitical tensions and the fragilities emerging from the private credit sector, it is reasonable to expect banks to tighten their lending standards in the coming months.
They are being encouraged to do so both by the ECB itself, which continues to tighten the regulatory screws on banks, and by national central banks, which despite the economic slowdown do not appear willing to reduce macroprudential capital buffers.
Turning to the less reassuring message, it concerns the effect of the war on inflation and growth. The ECB’s forecasts are based on data available up to March 11.
In the following days, however, it became increasingly clear that oil prices — and, consequently, the economic effects of the war — no longer depend on Trump’s statements or on developments on the ground, but on the prospects for reopening the Strait of Hormuz. As long as it remains closed, oil and gas prices will stay high, potentially above current levels.
Reopening the strait requires Iran’s agreement, which will be possible only if there is a truce on terms acceptable to Tehran.
That means the ECB’s baseline scenario — with inflation rising to 3 per cent in the second quarter of this year before falling back to 2.8 per cent by year-end, and GDP slowing by around 0.3 per cent in 2026 — looks optimistic.
The ECB has also presented two alternative scenarios, based on assumptions of higher oil and gas prices for a longer period. These imply significantly higher inflation this year — up to 4.4 per cent — and growth cut in half.
Under such conditions, pressure on European governments to adopt support measures for businesses and households would rise sharply.
That would have an expansionary effect on public finances and make the rise in inflation more persistent. Experience also shows that once the road of subsidies has been taken, it is difficult to reverse course.
At that point, the ECB would have little choice but to raise interest rates.
A first version of this article was published in the Italian daily Il Foglio
IEP@BU does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
