Energy tensions, inflation and monetary policy in the euro area

The conflict in the Middle East represents a disruption to global supply and, therefore, may drive up inflation and hinder economic activity. The question is whether the magnitude, persistence and propagation of the disruptions will result in a change in the economic outlook or merely a recalibration of forecasts. Although uncertainty is very high, the nature of the shock brought back memories of Russia’s invasion of Ukraine in 2022. But the two shocks are different.

In 2022, the stress was not only a matter of rising oil and gas prices but also a problem with energy flows themselves: Europe had to reconfigure its supply chains due to its high dependency on Russia. In contrast, Europe’s direct dependencies on the Middle East are limited (see first chart) and the supply disruption mainly affects Asia.

On the pricing side, between February and March, the futures markets shifted from quoting averages for 2026 of 65 dollars per barrel of Brent and 30 euros per MWh of TTF gas to between 80 and 90 dollars for Brent and 45 and 55 euros for TTF (see second chart). Despite the significance of the change, the shock was much stronger in 2022: whereas in mid-2021 the respective prices for 2022 were quoted at 70 dollars and 25 euros, the year’s average ended up being 100 dollars and 130 euros, resulting in annual energy inflation of nearly 40% in the euro area.

• 1

  In February 2022, the ECB had the official rate at a historic low of –0.50% and was implementing unconventional policies, including both net asset purchases (PEPP and APP) and long-term liquidity injections (TLTRO-III).

• 2

  We use paths for oil and gas prices according to the futures referenced between March and December 2026 and quoted throughout March. The range is framed between the 30% and 99% price percentiles. These paths translate into energy inflation with linear regressions that fit well: one between oil and the HICP for fuels and lubricants, and another between gas and the HICP for energy excluding fuels.

• 3

  See the article «Geoeconomic exposure and strategic relevance of the Middle East» in this same Monthly Report.

• 4

  We reproduce the methodology used by Fagandini et al. (2024), «Decomposing HICPX inflation into energy-sensitive and wage-sensitive items», ECB Economic Bulletin 3/2024, to calculate an «energy-sensitive» HICP. After assigning energy intensity among 103 items of the HICP, we transmit to them the increase in energy costs based on the ratio between the energy intensity of each component and that of purely energy items.

• 5

  The exercise identifies food and services related to transport and the repair of goods as the most likely sectors to suffer indirect effects from energy.

• 6

  After the peak in energy inflation in 2022, it took 9 months for the inflation peak in non-energy goods to materialise, while the time lag was 10 months for food, and 14 months for services.

• 7

  Based on De Mazelis et al. (2023), «Monetary policy strategies for the euro area: optimal rules in the presence of the ELB», ECB Working Paper, we use the rule: \(i_t=\rho(i_{t-1}-i_{t-1}^\ast)+(1-\rho)\lbrack1,5\cdot({\mathrm\pi}_{\mathrm t}-2)+{\mathrm y}_{\mathrm t}\rbrack\), where i* is the natural interest rate, π is inflation and y is the output gap (difference between observed and potential GDP). We assume a nominal natural rate of interest of 2% and an initial output gap of zero. The parameter ρ measures the gradualness of the response.

• 8

  Based on the behaviour of energy futures throughout March, most estimates point to a markedly more moderate impact on economic activity than on inflation (reflecting the euro area's low direct exposure and its greater energy resilience). Thus, we feed the Taylor rule with the adverse and severe GDP scenarios presented by the ECB last March, projecting growth within the 0.4%-1.2% range.

This exercise does not rule out the possibility that the ECB could barely react at all to the energy shock, relying instead on its transitory nature and the favourable starting point of the euro area’s economy and monetary policy. Nevertheless, there is also the possibility of a scenario in which the combination of a more severe and persistent energy shock and a swift response from the ECB could lead to a tightening of interest rates similar to that priced in by the financial markets in March. In such a scenario, the ECB could shift from a clearly neutral monetary policy to interest rates that would lie between the upper band of what would still be considered neutral and the lower band of a restrictive policy.