Mike Dolan: ECB hawks want a rematch in 2021/22 after the Iran oil shock

Hawks at the European Central Bank are eager to change history. The energy price shock this month may not be as severe as the fallout of Russia's invasion in Ukraine, but officials seem to be wary of repeating their'slow' post-pandemic tightening policy that left them scrambling back in 2022.

There will be intense debate in the ECB Governing Council about how and when to react to this potential inflationary spike in oil and gas prices. Few will be able to make a decision as soon as the next policy meeting due to the uncertainty surrounding the Iran conflict.

The financial markets don't wait to see who will win. Money markets shifted Tuesday to fully pricing an ECB rate increase by July - a radical shift from the flat policy horizon only a few short weeks ago when markets even flirted with the possibility of a further cut.

The hawks are out in force – perhaps the markets have listened more carefully after recent speculation that ECB president Christine Lagarde could step down as early as this year.

Joachim Nagel - the well-known policy hawk and Bundesbank chief – made his opinion on Wednesday clear.

Nagel said that "we must be very vigilant" and added that the debate over a possible undershoot in inflation, as well as further easing has ended.

If it is apparent that current increases in energy prices will lead to a broad increase in consumer prices in the medium-term, the Governing Council of ECB will take decisive action in a timely fashion.

This comment is a heavy lifter.

This is because the ECB – and many other major banks – still have a bruise from trying to see through a post-pandemic "transitory inflation surge", stoked primarily?by economies that were rebooting after COVID-19 and massive fiscal rescue spending.

In retrospect, it probably hurts to leave ECB rates in negative territory while headline inflation in the euro zone soared from 2% up to almost 6% over eight months until February 2022.

Isabel Schnabel, ECB Board member, went a step further by saying that there were "scars" from the high-inflation episodes.

DO NOT RELY ON LUCK

Even though it may have been okay then, the entire picture was left vulnerable to another "out of the blue" event.

After Russia invaded Ukraine and sent natural gas and oil price soaring, an event that the central bank could not have reasonably predicted, euro zone inflation soared above 10% in later years.

In July, the ECB finally acted. It raised rates from zero to 4% within 14 months. A year later, inflation returned to its target. The cost was high: increased energy bills, generalized inflation, and a sharp rate shock to businesses, households, and the economy as a whole.

This sequence of events was unlucky for many. But it also showed the dangers of not acting quickly to stop inflation above target, inflation expectations rising, and other second-round effects, such as business margin padding and wage negotiation pressure.

They argue that the ECB had to slam on the brakes more than was necessary because of the delay.

Klaas Knot is another former Dutch central banker who has been widely tipped as a potential successor to Lagarde. He made this point in a podcast last week with Brussels think-tank Bruegel.

Knot stated that "the lessons (from 2021-22) are that, while standard theory dictates that you look through a supply shock as an energy shock, it is important to be very, very cautious of non-linearities, and second-round impacts."

He said that if necessary, if a response similar to 2022/23 was required, the ECB could refer back to its playbook.

Of course, there are many arguments against this. The most obvious is that we do not know the full extent of the Gulf oil spill and an overreaction could be unnecessarily harmful.

ECB Vice-President Luis de Guindos warned on Wednesday that stoking financial market volatility could cause its own problems.

Others feel that comparing 2021/2022 to today is unfair, because fiscal and monetary policies were looser then.

Schnabel also argued that energy supply shocks today are different than they were four years ago. The earlier one was a more permanent reduction of Russian oil and gas supplies, and this month is likely to be a temporary suspension of Gulf exports.

Markets seem to be predicting that the ECB will act more quickly in the future to avoid the need for harsher actions.

If oil and gas prices do not fall soon, a warning to those who set the price may be on the way.

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(source: Reuters)