ECB head Lagarde thinks businesses may be quick to raise prices due to Iran war

European Central Bank Warns of Quicker Price Hikes as Middle East Tensions Impact Oil Markets

European Central Bank President Christine Lagarde warned Wednesday that businesses might raise prices more rapidly in response to oil shocks triggered by the Iran-Israel conflict, citing lingering trauma from the 2022 inflation surge that followed Russia’s invasion of Ukraine.

“If oil and gas prices continue to rise, the response of firms and workers may be faster than last time,” Lagarde said during a conference in Frankfurt, Germany. “We have a more recent memory of high inflation, which could affect how quickly costs are passed on and compensation is sought.”

The ECB chief emphasized that the recent experience with high inflation has fundamentally altered economic behavior across the eurozone. “That experience has left a mark,” she noted. “An entire generation has now lived through its first episode of high inflation — and it may not be as slow to react a second time.”

Inflation in the 20 countries using the euro currency reached a peak of 10.6% in October 2022, largely driven by energy price spikes after Russia curtailed natural gas supplies to Europe. The ECB responded with aggressive interest rate hikes that successfully brought inflation down to 1.9% by February 2024, according to Eurostat data.

Lagarde clarified that central banks typically avoid raising interest rates in response to temporary energy price spikes, as monetary policy cannot directly lower oil prices. “If the energy shock is seen to be limited in size and short-lived, the classical prescription of looking through should apply,” she explained, noting that rate hikes take months to affect the economy and might only take effect after the inflationary spike has subsided.

However, the current geopolitical situation presents unique challenges. The escalating conflict between Israel and Iran has already caused volatility in global oil markets, with crude prices fluctuating on fears of supply disruptions from the Middle East. If these higher energy costs begin to influence wages and prices across broader sectors of the economy, the ECB might need to take action.

The ECB president did offer some reassurance, pointing out that the current oil price increases are less severe than those experienced in 2021-2022. This factor could limit inflationary pressures compared to the previous energy crisis. European economies have also diversified their energy sources since the Ukraine invasion, potentially reducing their vulnerability to supply shocks.

Nevertheless, Lagarde maintained that if inflation appears to be heading persistently above the ECB’s 2% target, “the response must be appropriately forceful or persistent.” She added, “It’s too early to say where in this spectrum we will need to be… We will monitor developments closely and set monetary policy as appropriate.”

The ECB held its key interest rate steady at 2% during its last policy meeting on March 19, after a series of rate hikes designed to combat the previous inflation surge. Markets are now closely watching for signs of when the central bank might begin cutting rates, a decision that could be complicated by renewed energy price pressures.

The broader economic implications extend beyond Europe. Higher energy costs could slow the global economic recovery and put pressure on central banks worldwide to balance inflation concerns against growth prospects. For eurozone countries with high debt levels, sustained inflation could further complicate fiscal challenges.

As tensions continue to simmer in the Middle East, European policymakers remain on alert for signs that temporary price increases might transform into more persistent inflation, requiring a shift in their carefully calibrated monetary strategy.