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Prolonged war in the Middle East and a persistent fall in oil and gas supplies from the region could cause a “substantial spike” in inflation and a “sharp drop in output” in the Eurozone, the European Central Bank’s chief economist has warned.
In an interview with the FT, Philip Lane said that “directionally, a jump in energy prices puts upward pressure on inflation, especially in the near term”, and that such a development would be “negative” for growth.
European gas prices shot up almost 50 per cent at one point on Monday, after Qatar halted liquefied natural gas production following strikes from Iran, which has come under attack from the US and Israel since Saturday.
Oil prices increased almost 7 per cent to $77.74 a barrel because of a near-complete halt of shipments through the Strait of Hormuz, the strategic seaway through which roughly a fifth of the world’s oil and LNG flows.
The magnitude of the shock from the Middle East would depend “on the breadth and duration of the conflict”, Lane said. He added that “the impact would be amplified if it also gave rise to a repricing of risk in financial markets”.
The ECB “will be closely monitoring developments”, Lane said. He cited a scenario analysis it published in December 2023 that highlighted “a substantial spike in energy-driven inflation and a sharp drop in output” if a conflict in the Middle East led to a “persistent drop in energy supplies” as well as “disruptions in regional economic activity”.
In the analysis, the ECB modelled a third of the oil and gas transiting the Strait of Hormuz was disrupted. In such a scenario, its economists estimated oil prices, which at the time were roughly $80 a barrel, would rise more than 50 per cent to about $130 a barrel. Growth in the Eurozone would be 0.6 percentage points lower in the subsequent year, they said, while inflation would be more than 0.8 points higher.
Prior to the war, ECB economists had predicted annual inflation would fall slightly below the central bank’s 2 per cent target between the second quarter of this year and the end of 2027, before returning to 2 per cent in 2028.
Investors currently see an 88 per cent chance that the ECB will leave interest rates unchanged at 2 per cent this year, according to Reuters data.
Lane said he does not see any reason to change the central bank’s stance: “I think where we are now is OK.”
Barring a big and lasting shock from the Middle East, the Eurozone economy was “growing in the neighbourhood of its potential”, Lane said, adding he does not see meaningful risks of overheating.
“In 2023 and 2024, growth was below potential. There is still spare capacity, particularly in manufacturing,” he said, adding “we would need a period of above-potential growth in order to run that down”.
He also stressed that inflation, excluding volatile energy prices, was still higher than the ECB’s medium-term 2 per cent target and compensation per employee late last year was slightly higher than expected.
“This is not an environment where I see an argument in favour of taking a bit of risk on inflation,” he added.
Read the full transcript of the FT’s interview with Philip Lane on Monetary Policy Radar here.