By Balazs Koranyi LJUBLJANA, April 1 (Reuters) - The euro zone economy may already be on the "adverse" path outlined by the European Central Bank and inflation could become entrenched quicker than in
Euro Zone Economy May Be On ECB’s Adverse Path, Policymaker Warns
ECB Policymaker Raises Concerns Over Inflation and Economic Outlook
By Balazs Koranyi
LJUBLJANA, April 1 (Reuters) - The euro zone economy may already be on the "adverse" path outlined by the European Central Bank and inflation could become entrenched quicker than in 2022 as memories of rapid price rises shape consumer behaviour, ECB policymaker Primoz Dolenc said.
Inflation jumped above the ECB's 2% target last month as energy costs rose because of the war in Iran. The ECB has warned it may need to raise interest rates if the price surge spreads across the broader economy.
The bank has also sketched out adverse and severe alternatives to its baseline outlook, each implying higher and longer-lasting inflation and a bigger hit to growth.
Adverse Scenario May Become the New Baseline
"My personal impression is that baseline scenario appears to be more like a best-case scenario for the future and probably the current adverse scenario is more likely to be our next baseline," Dolenc told Reuters in an interview.
Risks of Second-Round Effects
Such a deterioration in the outlook - driven entirely by the war dragging on - risks pushing companies and households to raise price and wage expectations, triggering so-called second-round effects. These are the ECB's main concern because they can make inflation self-reinforcing.
"Second-round effects might not take as long to take hold as in our last inflation episode," Dolenc said. "People and firms have fresh memory of the inflation spike in 2022. And this is one of our biggest worries."
ECB’s Response to Shifting Expectations
Market Expectations for Rate Hikes
ACT QUICK IF EXPECTATIONS SHIFT
Financial investors now expect between two and three ECB rate hikes this year, with the first fully priced in by June.
Conditions for Policy Action
Dolenc said the ECB should not react to short-term price spikes, but must be ready to move quickly if energy inflation starts to spread to other goods and services or if workers factor higher inflation into wage demands.
"If there is a sign that higher energy prices will seep into other parts of the economy fairly quickly, and inflation expectations will rise quickly because of the memory effect, then we would need to consider acting sooner rather than later, in part to preserve our credibility," Dolenc said.
Upcoming Data and Policy Decisions
The ECB may not have all the necessary information by its April 30 meeting, but will receive a large flow of data, including detailed March inflation figures, energy market information and sentiment surveys. Policymakers will also see how the war develops.
While some officials, such as Bundesbank President Joachim Nagel, have said a rate hike as soon as April is an option, others - including ECB board member Isabel Schnabel and Cypriot central bank chief Christodoulos Patsalides - have warned against moving too fast.
"We cannot say today whether we'll have enough information by April 30," Dolenc said. "If we don’t have enough information, then probably it would be worthwhile to wait until June, when we have updated projections for next three years."
But if it looks like the war will drag on, high energy prices may spread through the economy and inflation expectations will rise, the ECB may need to act as soon as this month, he said.
"We will not be simply driven by market expectations," Dolenc said. "But we will for sure do whatever we can to bring inflation down to our 2% target in the medium term."
Further Reading
For the Q&A of this interview, click here.
(Reporting by Balazs Koranyi. Editing by Mark Potter)
