The European Central Bank warned in late April that the war in Iran is creating an energy-price shock that may raise consumer price expectations [1].
This development threatens to destabilize the euro-zone economy by cementing high inflation into the medium-term outlook, potentially forcing the central bank to maintain or raise restrictive interest rates despite slowing growth.
Researchers at the ECB said the conflict is fueling an energy-led rise in inflation, which creates a "double scar" on the expectations of consumers [2]. This phenomenon occurs as the current crisis follows previous inflationary pressures, marking the second energy shock in less than five years [5].
According to ECB researchers, "Consumers may be carrying a 'double scar' from recent inflation and repeated geopolitical shocks" [2].
These inflationary pressures are already evident in several major economies. Inflation remains above the ECB's 2% target in France, Italy, and Spain [1]. The challenge for policymakers is compounded by a deteriorating economic environment; euro-zone economic activity shrank at its sharpest rate in more than two and a half years in May [4].
On April 30, the ECB kept interest rates on hold [3]. However, the persistence of energy-driven inflation may limit the bank's flexibility. Financial markets currently price a probability of roughly 90% for a rate hike in June [6].
Officials in Frankfurt said they are monitoring whether these price expectations become entrenched. If consumers believe prices will continue to rise, it can create a self-fulfilling cycle that makes inflation harder to curb without severe economic contraction.
“Consumers may be carrying a "double scar" from recent inflation and repeated geopolitical shocks.”
The ECB is facing a 'stagflationary' trap where it must combat rising inflation caused by external geopolitical shocks while the underlying economy is contracting. The 'double scar' refers to a psychological shift in consumer behavior; if the public accepts high inflation as a permanent fixture due to repeated shocks, the ECB may be forced to raise interest rates further to break that expectation, even if doing so risks deepening the current economic recession.
