Commerzbank’s Chief Economist Dr. Jörg Krämer argues that the European Central Bank should respond to the recent Oil price shock by prioritizing long-term inflation expectations. He notes that higher energy costs are both lifting inflation and weighing on growth, creating a policy dilemma. Krämer concludes that if expectations drift above 2%, the ECB should raise rates, potentially as early as its late-April meeting.

Oil shock complicates ECB policy choices

"The ECB faces a difficult decision due to the oil price shock. The sharp rise in inflation would, in itself, suggests raising policy rates to bring the inflation rate back down to the 2% target. However, the higher oil price is simultaneously dampening economic activity, which will later bring inflation back to target and, in itself, argues for keeping interest rates unchanged."

"To make the right decision in this difficult situation, the ECB should focus on the long-term inflation expectations of citizens and businesses, which can be estimated from financial market data and surveys. If people expect the ECB to achieve its inflation target of 2% in the longer term, the ECB does not need to raise its key policy rates."

"However, if inflation expectations rise significantly above 2%, they become a self-fulfilling prophecy. For example, if unions anticipate high inflation in the coming years, they will demand higher wage increases today and drive inflation upward."

"If long-term inflation expectations rise, the ECB should act quickly and raise its policy rates. This weakens the economy and thus the bargaining position of workers and the pricing power of companies; they do not trigger a wage-price spiral."

"If the ECB does not raise its rates despite rising long-term inflation expectations, it will have to raise them even more sharply later on. For example, the U.S. Federal Reserve had to raise its interest rates to nearly 20% in the early 1980s to curb inflation that had spiraled out of control in the 1970s."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor.)