Can the ECB manage Europe's second inflation test?

The ECB enters the current energy shock from a position of relative strength. Inflation is close to target, policy rates are around neutral, and the labor market is cooler than during the 2022 episode. This has been reflected in a gradual cooling of wage demands prior to the jump in energy prices.

So far, inflation expectations remain relatively well anchored. Market-based measures have reacted only modestly, with the 5y5y forward rising slightly, while manufacturing selling-price expectations – although increasing – remain well below 2022 levels. We believe this suggests that, from an inflation perspective, the euro area is better positioned to absorb an energy shock than it was during the previous cycle.

From a growth perspective, the current shock comes at a more delicate stage of the cycle. The post-Covid surge in consumer demand has faded, and early data point to modest economic momentum before the Iran war started. Higher energy prices can take a significant bite out of disposable incomes, especially for lower- and middle-income households.

An analysis of previous energy price shocks, published by ECB staff, suggests that a 10% energy price shock could reduce consumer spending on essential items for these households by circa 0.4 percentage points. Business sentiment is probably also not immune to energy price shocks. Past experience suggests a negative impact on business fixed investment of circa 1.5 percentage points spread over a two-year period.

The growth impulse from additional fiscal spending to support European defense and German infrastructure thus appears to come at a good moment. It should at least help to prevent a scenario in which growth falls below 0.5%, while the consensus growth expectation for 2026 was 1.2% at the start of the year.

Energy prices remain the key uncertainty, with Brent for December currently hovering around USD 85 per barrel. A sustained period at these levels risks feeding into inflation expectations and firms’ pricing behavior, particularly as the ECB continues to monitor wage dynamics and supply-side pressures.

While the inflation impulse is less acute than in 2022, the combination of elevated energy prices and weaker growth creates a more challenging policy trade-off.

In today’s environment, the ECB appears to have more room for patience than in 2022. If energy prices stabilize around current levels, the most likely outcome is a pause in April, followed by gradual tightening starting in June.

However, the path remains highly conditional on energy developments. A renewed increase in prices would likely push the ECB toward a more aggressive hiking cycle, while a decline, particularly below USD 75 per barrel, could remove the need for further tightening.

Importantly, pushing the depo rate materially above 2.5% may prove difficult to sustain. The economic damage caused by restrictive monetary policy would increase the risk of subsequent rate cuts.