ECB Warns of Faster-Rising Inflation Expectations Amid Energy Shock

Inflation expectations across the eurozone could accelerate more rapidly than in previous periods, and the European Central Bank must be prepared to respond decisively with interest rate increases if sustained price pressures begin to take hold, policymaker Dimitar Radev has cautioned. The surge in energy prices driven by the ongoing Iran war has already pushed inflation well beyond the ECB’s 2 percent target, prompting internal debate over whether tighter monetary policy is needed to prevent the shock from spreading into broader price dynamics and triggering a self-reinforcing inflation cycle.

“The balance of risks has shifted in an unfavourable direction,” Radev, who also heads Bulgaria’s central bank and is among the newest members of the ECB’s Governing Council, said in an interview. “While the baseline remains our reference, ⁠the likelihood of a more adverse scenario has increased, particularly in light of the energy shock and the elevated level of uncertainty,” he added, referencing the ECB’s recently outlined scenarios of adverse, baseline, and severe economic outcomes.

A central concern for policymakers is the potential behavioral shift among consumers and businesses, particularly after the sharp inflation episode that followed Russia’s invasion of Ukraine. That experience may lead households and firms to react more quickly to rising prices by adjusting wage demands and pricing strategies, potentially igniting an inflationary spiral that becomes increasingly difficult and costly to contain. Radev highlighted this risk, noting that expectations may now respond more rapidly to economic shocks than in the past.

“Recent inflation developments appear to have increased the responsiveness of expectations, meaning that pass-through from new shocks can occur more quickly than under normal conditions,” Radev said. His remarks align with broader signals from other ECB officials, many of whom have stopped short of explicitly advocating for immediate rate hikes but have emphasized the importance of readiness to act if conditions deteriorate.

At present, inflation expectations remain broadly anchored around the ECB’s target, and there is little evidence of second-round effects in recent data. The March inflation reading, while showing a sharp rise in energy prices, indicated moderating pressures in the services sector. Nonetheless, Radev stressed that policymakers cannot assume such a benign trajectory will persist, given the fragile and rapidly shifting economic environment.

“If the shock persists and begins to affect wages, margins and expectations, the cost of inaction would increase,” he said. “In such a situation, acting in a timely manner would ⁠be the more prudent course.”

Financial markets have already begun to reflect these risks, with expectations building for more than two ECB rate increases this year and the first potentially arriving as early as June. Radev noted that it remains premature to determine whether sufficient data will be available by the time of the ECB’s April 30 meeting to justify a concrete policy decision. However, he indicated that the meeting should provide enough information to support a more structured and substantive policy discussion.

In the weeks ahead, the ECB will closely monitor a range of indicators, including inflation expectations, underlying price trends, sentiment measures, and developments in energy markets. Particular attention will also be given to the duration and broader economic impact of the Iran war, which remains a key source of uncertainty.

While the memory of the 2022 inflation surge may heighten sensitivity among consumers and businesses, Radev acknowledged that the eurozone enters the current situation from a relatively stronger position. Interest rates are already at higher levels, and inflation expectations, for now, remain contained—factors that may provide some resilience even as risks continue to mount.

By fLEXI tEAM