It cannot be repeated too often — energy shocks are awful for Europe. Energy is a necessity and Europe is a net importer, so if fossil fuels become more expensive Europeans have less to spend on other things. Governments can merely redistribute losses, while central banks cannot affect the energy price — so monetary policymakers must aim for the least bad macroeconomic impact.
Even that limited ambition is easier said than done.
In describing its likely response to the Iran war, the European Central Bank has been impressively swift in setting out a broad yet flexible action plan based on its scenarios for the war and energy prices.
Speaking at the ECB and its watchers conference in Frankfurt last week, central bank president Christine Lagarde first laid out the obvious. The optimal response will depend on the “intensity and duration of the shock and how it propagates”, she said. What was new was her “graduated” three-pronged strategy:
First, if the energy shock is seen to be limited in size and shortlived, the classical prescription of looking through should apply. Transmission lags mean that a monetary policy response would arrive too late and risk being counter-productive.
Second, if the shock gives rise to a large though not-too-persistent overshoot of our target, some measured adjustment of policy could be warranted. The optimal response to such a deviation is smaller when the cause is exogenous supply disruptions rather than strong demand, but it is not necessarily zero.
Moreover, to leave such an overshoot entirely unaddressed could pose a communication risk: the public may find it difficult to understand a reaction function that does not react.
Third, if we expect inflation to deviate significantly and persistently from target, the response must be appropriately forceful or persistent. Otherwise, self-reinforcing mechanisms would kick in and the risk of de-anchoring [inflation expectations] would become acute.
Playing tag with Lagarde, ECB chief economist and self-styled “numbers guy” Philip Lane took to the stage to define these principles more precisely. (Though you will not find a commitment to any particular interest rate response in his words or slides.)
Along with everyone I spoke to at the conference, my interpretation was that Lagarde’s three-pronged strategy maps broadly to the ECB’s “baseline”, “adverse” and “severe” scenarios.
I’ve drawn the ECB’s oil price scenarios below along with recent Brent crude prices and Monday’s forward curve. It is worth dwelling on the numbers here for a few seconds. Everything is worse now for the Eurozone than in the December 2025 assumptions. The oil price has already risen faster than the ECB’s March baseline projections, with current and future crude costs now closest to the ECB’s adverse scenario.
The shading on that chart matters when assessing the intensity of the shock in historical terms. Oil prices today are in the light grey zone, which is outside the normal inter-quartile range and close to the 95th percentile of the expected oil price distribution. It shows the ECB has produced scenarios that tell difficult stories about risks, rather than simply variants of the central forecast.
But note that current oil and natural gas prices are not yet as bad as the ECB’s severe scenario. And the severe scenario, as the chart below shows, is only roughly half as bad as Europe’s lived experience in 2021-22.
The economic effects of the scenarios are pretty sobering. Before the war the ECB could say the Eurozone economy was in a “good place”, with stable macroeconomics that allowed officials to focus on dynamism and structural reform. It now looks sickly. In the adverse scenario closest to market pricing, output broadly stagnates for the rest of 2026, followed by a gradual recovery to converge on the March central projection by the end of 2028. A deeper energy shock generates a mild recession.
Interestingly, these scenarios are much more explicit about the possibility of recession than the ECB dared to be in September 2022, when it predicted continued quarterly growth. That illustrates the central bank’s greater confidence and maturity about what can be published.
The ECB scenarios do not just differ on energy cost assumptions, but also on the expected response of companies and households to higher prices. This reflects the wide body of research that finds that although economic agents accept small inflationary shocks, they fight to defend their interests when price rises move some distance away from a central bank’s 2 per cent target. The threshold that motivates this behaviour is generally thought to be around 3 to 4 per cent.
As a result, the adverse scenario shows headline inflation getting to about 4 per cent, then falling back quickly with little effect on core inflation. In the severe case, above-target inflation persists and leaves core inflation higher for longer.
The most important thing is that all the forecasts are conditioned on the same ECB policy rates as the baseline, which means little change from the current 2 per cent level.
The results of the severe scenario, which forecasts excessive headline and core inflation for more than two years, would clearly not be acceptable and necessitate a forceful response from Lagarde. This would obviously mitigate the persistence of high inflation but deepen the recession already built in.
In the adverse scenario, in which core inflation moves up only a little and headline inflation comes back to target by mid-2027, the required policy response would be minimal. It would be best to think about a couple of rate rises this year, bringing the ECB’s deposit rate up to 2.5 per cent from the current 2 per cent. This would show that the central bank was not asleep on the job and that it aimed to prevent an excessive downturn.
These are my estimates and not those of Lagarde or Lane. Although the ECB had produced scenarios internally with policy response rules, it did not want to say anything that looked like a commitment, Lane said. The central bank also wanted to preserve its ability to be agile in response to this energy shock, he added, because the right response depended so crucially on how households and companies themselves behave.
In any case, Lane said, each meeting had a binary choice — do nothing or act. Getting geeky, he likened it to a statistical probit model in which the ECB would look at all of the data and decide whether action was needed or not.
That seems sensible. But it is not often I get to out-geek the ECB’s chief economist. Since his boss said the Governing Council would at each meeting have to decide whether to look through the energy shock, respond in a limited way or act forcefully, a standard probit model is the wrong econometric analogy.
Because it needs to decide whether it is in a bad, ugly or terrible place, the ECB should be thinking about an ordered probit instead.
What I’ve been reading and watching
One last chart
I am sorry to bring you this chart, but it is best not to put our heads in the sand. Remember when the Houthi rebels in Yemen attacked shipping they linked to Israel in late 2023, diverting away roughly half of Suez Canal traffic?
The chart below using IMF Portwatch data shows that despite US bombing and international diplomacy, the traffic never came back. The threat was too great. This does not bode well for the Strait of Hormuz.
The one important difference is that vessels can relatively easily sail around Africa to avoid the Suez Canal, while alternative options do not readily exist for the Strait of Hormuz. That boosts Iran’s leverage and increases the urgency to resolve this current bottleneck.
Central Banks is edited by Harvey Nriapia
