ECB’s Lane: Current energy shock is unfolding in a less demand-supportive environment

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Philip Lane, Member of the European Central Bank (ECB), told an audience in London on Wednesday that the propagation of the Iran shock may be more contained than in 2022, but stronger and faster than historical averages.

Key quotes:

Increase in selling price expectations suggests input cost pressures will map into higher output prices in coming months.

Firm-side and news-based indicators suggest current energy shock is unfolding in a less demand-supportive environment.

Propagation of Iran shock may be more contained than in 2022, but stronger and faster than historical averages.

A mid-size but not-too-persistent overshoot could warrant some measured adjustment.

In face of larger and more persistent overshoot, response must be appropriately forceful or persistent.

Demand destruction channels limit the required adjustment in the monetary stance, fiscal expansion does opposite.

Optimal response might be smaller for exogenous supply disruption than for demand shock.”

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The European Central Bank (ECB) in Frankfurt, Germany, is the reserve bank for the Eurozone. The ECB sets interest rates and manages monetary policy for the region. The ECB primary mandate is to maintain price stability, which means keeping inflation at around 2%. Its primary tool for achieving this is by raising or lowering interest rates. Relatively high interest rates will usually result in a stronger Euro and vice versa. The ECB Governing Council makes monetary policy decisions at meetings held eight times a year. Decisions are made by heads of the Eurozone national banks and six permanent members, including the President of the ECB, Christine Lagarde.

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In extreme situations, the European Central Bank can enact a policy tool called Quantitative Easing. QE is the process by which the ECB prints Euros and uses them to buy assets – usually government or corporate bonds – from banks and other financial institutions. QE usually results in a weaker Euro. QE is a last resort when simply lowering interest rates is unlikely to achieve the objective of price stability. The ECB used it during the Great Financial Crisis in 2009-11, in 2015 when inflation remained stubbornly low, as well as during the covid pandemic.

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Quantitative tightening (QT) is the reverse of QE. It is undertaken after QE when an economic recovery is underway and inflation starts rising. Whilst in QE the European Central Bank (ECB) purchases government and corporate bonds from financial institutions to provide them with liquidity, in QT the ECB stops buying more bonds, and stops reinvesting the principal maturing on the bonds it already holds. It is usually positive (or bullish) for the Euro.