Energy prices are rising: what does this mean for inflation and monetary policy?

Oil and gas prices have risen sharply due to supply disruptions in the Middle East

The war in the Middle East has caused oil and gas prices to rise. At the time of writing in mid-April, oil prices stand at around $100 a barrel, while the European gas price hovers around €50 per MWh. In late February, oil was still trading at around $70 per barrel and gas at around €30 per MWh, meaning the current price surges are significant, at 40% and 60%, respectively. By way of comparison: in 2022, following Russia’s invasion of Ukraine, oil prices went up around 30%, peaking at more than $120 per barrel, while the price of gas more than tripled to over €300 per MWh (see Figure 1).

The current price rises are linked to widespread disruptions to energy supplies in the Middle East caused by attacks on production facilities in the region and the blockade of the Strait of Hormuz, through which a significant proportion of the world’s oil and LNG supplies passes. Uncertainty about the duration of the war and the possibility of further escalation is causing oil and gas prices to fluctuate sharply. This uncertainty, exacerbated by exceptional energy price volatility, significantly complicates economic forecasting.

How does the current situation differ from that of 2022?

Although the rise in energy prices is reminiscent of 2022, the current situation differs in two key respects.

First, the cause of the price rises is different. In 2022, the crisis was primarily a Europe-specific one, as Russian gas supplies dried up. The breakout of a war on the European continent also added to broad-based economic uncertainty. The current shock is more global in nature. Supply-side disruptions are now causing shortages in Asian markets, while Europe is mainly facing higher prices. This means the current shock has more similarities to a 'classic’ negative supply shock than the one caused by the Russian invasion of Ukraine. Furthermore, today’s focus is less on gas, while oil is playing a greater role than in 2022 (see Figure 2).

ASecond, the economic context is different. In 2022, Russia cut off gas supplies just as the European economy was reopening following the pandemic and global supply chains were grappling with persistent disruptions. Demand was strong, the labour market was tight, and core inflation had already risen before the war against Ukraine broke out (see Figure 2). This increased the risk of more widespread price rises. In the current situation, such conditions seem to be lacking. Economic growth has slowed slightly, demand-side pressures have eased somewhat, and the earlier supply-side disruptions have largely disappeared. This reduces the likelihood of higher energy prices once again causing prolonged and widespread inflationary pressures.

How do energy prices affect inflation?

Rising energy prices can feed through to inflation in various ways, but the extent to which this happens depends on economic conditions.

Both in 2022 and now, inflation began to rise due to higher energy prices. Fuels, gas and electricity are part of the official basket of goods used to calculate inflation. Fuel prices respond quickly to higher oil prices, whereas household energy bills rise with a lag as many households are on fixed-term contracts. In 2022, gas played a particularly significant role, whereas at present it is mainly oil and fuels that are putting pressure on prices.

In addition, higher energy prices have an indirect impact on business costs, for example through production and transport costs. Firms are trying to pass on these higher costs, but this will only work if consumers are able and willing to pay them, something that is harder to achieve in times of uncertainty and cautious spending. Past experience shows that the impact of energy prices on inflation is less pronounced in a weak economy, such as around 2010, or at times of subdued economic growth, as is currently the case, than during an economic boom, such as in 2022.

Finally, so-called second‑round‑effects may occur. If employees expect inflation to rise, they will demand higher wages in negotiations with employers to maintain their purchasing power. They are in a stronger position when the economy is doing well and the labour market is tight. However, the resulting wage increases drive up business costs and may spur further price rises. In this way, a transitory spike in energy prices can cause persistent inflationary pressures.

The probability of such a scenario can be assessed using indicators of inflation expectations, which indicate whether price rises are considered temporary or are likely to feed through into wages and prices. Looking at inflation expectations in financial markets, the data so far suggest that they are stable and have remained anchored near the 2% target in the longer term (see Figure 3). At the same time, there is a risk that the expectations of households and businesses will react more quickly and have a greater impact, as the inflation peak of 2022 is still fresh in people’s minds.

How can monetary policy respond?

Monetary policy cannot prevent or restore the loss of energy supply. As such supply shocks often lead to higher inflation and lower economic growth, this presents central banks with a difficult trade-off. Curbing inflation comes at the expense of economic growth, which is already under pressure due to the supply shock. While the direction of monetary policy is obvious in response to a supply shock – higher inflation requires an interest rate hike – its timing and extent require careful calibration.

This is because it is impossible to predict in advance exactly how long a supply disruption will last, or whether further shocks will exacerbate its impact. For this reason, monetary policy can never be decided in advance. Central banks must continually assess the situation and consider various possible developments and scenarios.

An additional complication is that monetary policy always takes time to have an effect on the economy. Changes in interest rates only affect spending, investment and prices over time. This requires looking ahead: policymakers must act based on current signals, while any impact will make itself felt further down the line.

If a supply shock is manifestly minor or transient, it is therefore often advisable not to intervene too soon, particularly if the economy is already in a weakened state. However, as the scale of a shock increases and it becomes less certain whether price rises will subside quickly, adopting a wait-and-see approach becomes riskier. In such cases, intervention may be necessary to prevent inflation from rising too sharply and confidence in price stability from eroding.

The current situation facing the ECB

The European Central Bank (ECB) is currently well placed to make adjustments. The key policy rate stands at 2%, which is close to neutral at a level that neither stimulates nor slows down the economy.

Should interest rates be raised, or not?

The key question is whether the current energy price shock is short-lived or results in persistently high inflation. The ECB is naturally monitoring developments in the Middle East, but is first and foremost on the lookout for signs of underlying price pressures, such as wage trends and inflation expectations in the euro area. As long as these indicate limited pass-through, there is no need for a sharp interest rate hike.

This could change if price rises become more widespread and prove to be more persistent. In that case, there is an increased risk that inflation will remain above the 2% target for a longer period, which may require a more decisive policy response. The ECB is closely monitoring conditions and stands ready to adjust its policy as the situation requires.