Europe Should Resist Monetary Tightening After Energy Shocks
Supply-driven inflation calls for fiscal and industrial action, not higher interest rates that risk choking off recovery. A commentary by Marco Buti, and Marcello Messori
Compared with the 2020–2022 period, the European Union has reduced its dependence on oil and gas, though not on other critical inputs such as fertilisers, heavily affected by disruptions linked to the closure of the Strait of Hormuz. It has also streamlined its position in global value chains.
Yet the severity of current geopolitical conflicts and the resulting economic disorder are likely to generate supply-side bottlenecks that will prove difficult to resolve in the short term — and will weigh heavily on the European Central Bank’s monetary policy choices.
Before the US-Israeli attack on Iran, the European economy had largely absorbed the previous inflationary surge and, from 2025 onwards, was emerging from the stagnation of the preceding two years.
At the same time, albeit imperfectly, EU institutions were attempting to coordinate higher national defence spending and to initiate common industrial policy projects.
Following the attack, however, it is reasonable to expect — much as during the Covid crisis — that supply constraints will tighten and inflation will once again rise significantly above the 2 per cent target.
There is also a risk that geopolitical fractures become sufficiently deep to prolong these constraints, further exacerbated by Europe’s retreat from the transition towards sustainable energy sources.
In such a context, monetary tightening in response to a negative supply shock would stifle the nascent recovery in demand.
In the absence of an effective policy mix combining monetary and fiscal tools, ECB president Christine Lagarde has warned that the central bank may have little choice but to act.
Europe’s decisions are made more complex by uncertainty surrounding the US policy mix. Thanks to its greater availability of traditional energy sources, the US economy is likely to face less severe short-term energy shocks and production bottlenecks than Europe.
However, fiscal policy is fuelling investment in artificial intelligence and associated consumption, even as inflation has exceeded 4 per cent.
Price dynamics have come to dominate domestic political debate, particularly around affordability, prompting the outgoing Federal Reserve chair to signal the likely need for higher policy rates.
Yet, with elections approaching in the autumn, monetary tightening appears unlikely in the near term, raising the risk of more disruptive inflation.
Against this backdrop, the EU has an opportunity to position itself as an “island of rationality”.
Policymakers should make clear that upward pressure on prices in Europe stems from a severe supply shock that alters the terms of trade.
As such, the most effective response lies in expanding supply rather than compressing demand. Fiscal and industrial policies must address supply bottlenecks, while the ECB should effectively “freeze” its monetary stance.
The likelihood of such an outcome, however, remains uncertain. The growing dominance of national sovereignties within the EU makes the centralised policies required to boost aggregate supply difficult to implement.
Even if recent European Council conclusions were to lead to the completion of the single market by 2027, alongside the implementation of an Industrial Acceleration Act, the resulting expansion of supply would be gradual and largely confined to the medium term.
Achieving tangible short-term results would require tackling politically sensitive issues: strengthening the EU budget to finance European public goods and completing financial market integration.
Without these steps, initiatives such as the so-called “28th regime” would fall short of expectations. Should political and institutional constraints prevent progress, there is a risk of resorting to second-best solutions — notably further relaxation of state aid rules, resulting in uncoordinated national subsidies lacking the scale and balance of the pandemic response.
In a situation even more severe than that of 2022–2023, the EU must deliver a strategic policy mix in which fiscal and structural measures support aggregate supply, rather than leaving monetary policy alone to contain inflationary pressures.
Under such conditions, the ECB could adopt a prudent “wait and see” approach, instead of raising interest rates and withdrawing liquidity.
In the opposite scenario, it would be forced into restrictive policies that address the imbalance between supply and demand from the wrong side of the market, resulting in outcomes that are both socially inequitable and economically inefficient.
In speeches at Davos and at the Munich Security Conference, Lagarde has pointed Europe towards a more mature role, moving beyond its traditional model of “limited responsibility”.
In a geopolitical landscape shaped by conflict and fragmentation, the EU must think big. If it responds effectively to the energy shock, it could emerge as a central actor in a new international order. The question is whether it will rise to the challenge.
A previous version of this article was published by the Italian daily Il Sole 24 Ore
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.
