How to Coordinate European Energy, Fiscal, and Monetary Policies in a Fragmented World

This commentary builds on ongoing work carried out by the authors as part of a new two-year project funded by Partners for a New Economy (P4NE). The project rethinks monetary policy and central bank actions – including their interactions with fiscal policy – in response to structural challenges such as climate change, geoeconomic fragmentation, innovation, and demographic shifts

One month into the US-Israeli attack on Iran and the ensuing regional conflict, the trajectory is clear: unless hostilities cease immediately, the EU will face a new wave of inflation driven by energy and food.

Gas and oil supplies are tightening due to strikes on energy infrastructure – potentially with lasting effects – and the closure of the Strait of Hormuz. Fertilizer supplies, heavily dependent on fossil fuels, are also under threat, adding further pressure on food prices.

When assessing the impacts of these shocks on EU economies, the conventional narrative is as follows: such exogenous supply shocks will initially affect headline inflation, which excludes energy and food prices.

However, they will eventually feed into aggregate demand (if workers secure wage increases in response to rising prices) and/or into inflation expectations, whereby economic agents systematically anticipate continued price increases in their production, investment, and consumption decisions.

Consequently, central banks should raise interest rates sooner than later. While such tightening may increase unemployment, monetary policymakers deem it a necessary sacrifice to anchor expectations and wages, thereby keeping inflation in check.

Reassessing the usual story

The problem with this narrative is that it treats energy, fiscal and – especially – monetary policies as three independent domains that must remain separate. Yet in reality, these domains are deeply intertwined.

As such, in the face of current and potential future shocks – in a world marked by geoeconomic fragmentation and climate change – these domains must be approached as complementary components of a single policy mix. Three reasons support this.

First, energy policy directly determines inflation trends. Rather than theorizing, consider the divergent impact of rising gas prices across the EU: in Spain, the wholesale electricity price is less affected by ongoing events and is considerably lower than in other EU countries such as Italy. Why?

Since 2019, Spain has added 40 GW of wind and solar capacity, drastically reducing the frequency with which gas is needed – and thus the frequency with which it sets prices under the merit order system, where the last plant dispatched sets the price.

Second, monetary policy has limited ability to fight inflation caused by energy supply shocks – a limitation that some central bankers themselves acknowledge.

The primary monetary policy tool – setting interest rates – is far more effective against demand-led inflation than supply-led inflation. As such fiscal policy, rather than monetary policy, is critical to address situations such as the current one.

Potential measures can include: targeted energy vouchers for exposed households and firms; expanding social leasing schemes for electric vehicles; and scaling up public investment in renewable energy and electrification.

While taxation and private capital can help fund some of these expenditures, public debt will likely have to rise in the short term – though less than in a fossil fuel dominated energy system that is subject to continual price shocks.

Third, given that conducting these “energy-conscious fiscal policies” implies an increase in public and private investments, the ability to make such investments is largely determined by monetary policy.

In particular, when central banks raise interest rates, they directly undermine the capacity of highly indebted governments (and private actors) to invest in the transition.

Empirical evidence shows that restrictive monetary policy can significantly impact the pace of renewable energy capacity installation.

Whither fiscal-monetary coordination in the age of energy shocks?

While addressing these issues is clearly difficult, certain concrete measures deserve more explicit public debate.

For instance, central banks could extend their time horizons and therefore “look through” energy-driven price spikes for longer periods of time, giving governments room to respond.

Moreover, since government action is essential to achieving medium-term price stability, yet costly in the short term, central banks could explicitly support it by prioritizing green sovereign bond purchases on the secondary market.

While the measure may sound radical, it would be a way of valuing long-term resilience that private market participants – typically focused on the short-term – cannot integrate on their own. Alternatively, if raising interest rates is unavoidable, central banks could introduce dual interest rates to shield activities that finance the energy transition.

In addition, this policy coordination needs to come at a peculiar historical moment: trust in the US dollar is eroding, and emerging currencies – notably China’s renminbi – are on the rise.

In this context, EU monetary and fiscal authorities must coordinate to ensure that the euro remains globally attractive in the context of its energy transition.

The ECB and some euro area national central banks have already taken initial steps, by more or less timidly supporting initiatives such as the digital euro, eurobond issuance or the provision of credit lines to other central banks.

Future efforts should anchor these measures in the context of the energy transition. For instance, credit lines and swap lines could target strategically important partner countries in the quest for resilient, green supply chains.

Some may argue that such actions would erode central bank credibility and potentially exacerbate inflation as a result. Yet clinging to the status quo and siloed policymaking in such a context is equally dangerous, as it would fail to address the multiple trade-offs across monetary, fiscal and energy policies.

Beyond the status quo and a populist approach (“à la Trump”) to central banking, another pathway – anchored in a realist approach to the transition in a geoeconomically fragmented world – is possible and needed.

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.

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