ECB must be prepared to act as inflation scars risk quickly raising expectations, policymaker says

SOFIA — Euro zone inflation expectations are at risk of rising more quickly than in the past and the European Central Bank (ECB) must be ready to raise interest rates swiftly if ‌signs of persistent price pressures emerge, ECB policymaker Dimitar Radev said.

Surging energy costs prompted by the Iran war have already pushed inflation well above the ECB’s 2% target and policymakers are now debating whether to tighten policy to prevent this increase from becoming embedded in the price of other goods and services, setting off a ​self-reinforcing price spiral.

“The balance of risks has shifted in an unfavorable direction,” Mr. Radev, head of Bulgaria’s central bank and one of the newest members of the ECB’s Governing Council, told Reuters 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 said, referring to the three economic scenarios — adverse, baseline and severe — outlined by the ECB last month.

A key risk is that consumers and businesses, who experienced runaway prices only four years ago following Russia’s invasion of Ukraine, may quickly adjust their own expectations, demanding higher prices and wages, and setting off an inflation spiral, which then proves costly to extinguish.

BEHAVIORS HAVE CHANGED
“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,” Mr. Radev said.

His comments echo warnings from a host of other policymakers who have stopped short of explicitly calling for rate hikes but have said the ECB needs to stand ready to pull the trigger.

For now inflation expectations are holding ‌at the ECB’s target and second-round inflation effects are not visible in data such as the March inflation reading, which showed a jump on energy but signaled slowing price pressures for services.

But the ECB cannot take such a benign outcome for granted because the environment is fragile and prone to quick changes, Radev said.

“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.”

This risk is a key reason why financial markets have priced in more than two interest rate hikes from the ECB this year, with the first expected in June.

Mr. Radev said it was too early to say whether the ECB would have enough data by the time ​of its April 30 meeting to make a call but it would have sufficient data to allow for a more concrete and structured policy discussion.

The bank will be especially attentive to various measures on inflation expectations, underlying price figures, sentiment indicators, energy price developments and, most importantly, signals regarding the length of the Iran war and its effects.

While the 2022 experience could make consumers more edgy, Radev also acknowledged that the euro zone entered this crisis from a better position since interest rates are already higher, and inflation expectations are anchored.

The big risk now is that governments start implementing subsidies that could potentially add fuel to the fire, he added. — Reuters