And perhaps most importantly, via many financial institutions to households and firms making investment and savings decisions every day. And by the way, we're happy to have with us also Paul Mason and Gilchin Oskan as well as Harry Stellas who are respectively bringing together the Bank of England and the Swiss National Bank with their own watchers. And there is actually a similar forum now in the United States for some time, the US multipolicy forum. So I'm glad this has really become a trend and we should work together to keep it going.
There are always new challenges to debate, to discuss. And if you just think of now, until a few weeks ago, the ECB anticipated very stable growth around 1.4%, inflation locked in at the target of 2%, and interest rates around 2%, with no need for policy changes for a long time. And this projection was not only from the ECB but also from professional forecasters and many market participants, of course with a wide range of uncertainty.
Actually, on February 23rd, I had the opportunity to contribute a short background paper for the European Parliament's monetary dialogue with ECB President Lagarde. And in fact, I think some of the people who run this effort at the European Parliament are also here. And we had a little paper with an IMFS researcher, Henry Kimman. In the abstract, we wrote: under the impression of this outlook, the ECB anticipates remarkably stable growth and inflation while Europe is actually faced with geopolitical threats, a lack of competitiveness, and major fiscal challenges. So at such a time, central bankers need to consider the dynamics of risk scenarios that can arise from potentially misaligned or misperceived trends, policy-relevant parameters, and prepare for timely policy responses.
A few days later, the US and Israel launched attacks on Iran. The current escalation of the war in the Middle East could be considered the third battle in a war that started with the Hamas attack on Israel in 2023. However, it does form part of a horrible and deadly conflict that has been persisting for many decades.
So, focusing just on the economics, the risk scenario of a blockage of the Strait of Hormuz is not something new. It's a scenario which one could have or might have or actually has had in the drawers for a long time, not knowing if, when, how likely, how long. But that's exactly what scenarios are for. It's a tool that we as economists can offer to our policymakers, which is analysis based on certain conditions. Conditions which by themselves are not easily amenable to a probabilistic assessment, such as when such a blockage could occur or how long it would be. But given that it occurs, you can calculate how other things might be affected and give some probabilities to that.
On March 13, Kimman and I submitted a scenario analysis on the effects of this war for Euro area inflation for a report to our German Minister of Economic Affairs. Based on a fairly simple Euro area energy price model, it suggested that headline inflation could rise to about 3.5% and core inflation to about 2.5% within a year, under the condition that recent increases in gasoline, diesel, and natural gas prices would persist for two to three months and after that period be determined by the dynamics of that particular model.
So you can imagine I was very much looking forward to the assessment of the ECB staff that was published last Thursday, and I was very pleased to find that it contained three scenarios which were analyzed in great detail: a baseline scenario of 2.6% inflation in 2026, an adverse scenario with 3.5%, and a severe scenario with 4.4%. So, scenario analysis, and today we are looking forward to learn more in the next debate about the strategic considerations in view of this energy shock and other ongoing persistent challenges for monetary policy, not the least of it issues concerning central bank independence in certain jurisdictions.
In that debate, we'll have the ECB's Philip Lane, James Bullard from Purdue, a former member of the US Federal Open Market Committee, and Frank Smets from the Bank for International Settlements. In the afternoon, we will take an in-depth look at the international environment with Governor Orain and with perspectives from the US and China respectively by Professor Chin from the University of Wisconsin and Dr. Tao Wang from UBS Hong Kong. And we will conclude with a debate on what should be Europe's strategy for dealing with the broader challenges of our time by Governor Martin Koha, Professor Veronica Grim from the German Council of Economic Advisors, and Professor Luis Garisano from the LUISS School of Economics.
I mean, these programs are prepared a long way ahead of time. It always starts with a meeting with Philip Lane, talking about what issues could be relevant next year, and then we talk with our watchers. We have a circle of friends and get input and look around for people we know and that could talk to us. And I think again, I think we have a set of topics which speak to us at this juncture.
But now, President Lagarde, let me emphasize how extremely grateful we are to be able to start this day with your presidential address, and actually how extremely grateful we are that we have been able to do this for a number of years already. I mean, that's really amazing. Thank you very much for your leadership in this period. We just talked a little bit about when you started and presumably everything was calm, and we've had one crisis after the other, but your leadership has been essential in these years. Thank you for that.
Rather than going through your curriculum vitae, which is well known to participants here and I talked about previously, let me instead remind us of the important messages you have shared with us before at this occasion of the ECB Watchers. In 2022, that was actually the first large in-person event after Corona, and it was a few days after the start of the Russia-Ukraine war, you shared with us how to conduct monetary policy in an uncertain world and gave your view on that. In 2023, you delineated the path ahead amidst financial turmoil, and in 2024, you took strides towards building confidence in the path ahead. And in 2025, you laid out your view on a robust strategy for a new era. Thus, you can imagine we are waiting in great suspense for your message today. And by now, a lot of people here ask, why does he finally stop talking? You know, when and I will. So, I will. So, without much further ado, may I ask you to the podium? Thank you very much for joining us today.
Thank you very much, Professor Wieland, and good morning to all of you. Thank you particularly for convening a family reunion. And you know, given that we are this family, I would like us to take just one minute to celebrate one member of the family who is soon going to enter its 10th decade. And I leave it to the economists and the number guys and gals in the room to figure out how old he is, but I would like a big round of applause for the first chief economist of the ECB, Otmar Issing.
So, my dear Volker, if you had called this meeting a month ago, my speech today would have been entirely different. And the excellent economists and speechwriters and experts who helped me draft those wonderful words had to just delete everything that they had worked on and start all over again. And what's more, we had to update almost on an hourly basis. I suppose that's what you all do as well.
So if it had been a month ago, the Euro area economy had ended the year with solid growth momentum. Inflation stood last reading at 1.9% in February, and domestic growth engines looked to be strengthening, particularly private consumption that we had been anticipating, and investment in particular in digitalization and defense spending. That was a month ago. Today is March 25th, and wars are raging.
We find ourselves yet again in a different world whose contours are not yet clear. We are facing profound uncertainty about the path that the economy will take. None of us can resolve the uncertainty about how and when the Ukraine war will end and how the war in Iran will play out. But what I want to do today is set out how we will approach this last shock. And the main message I want to convey is that our response will be rooted in our monetary policy strategy that I spoke about in 2025, as you mentioned, and I believe that it equips us well in order to navigate the shock that we are facing.
Our strategy, if you remember, sets out three key principles, and they will guide us. Principle number one: it requires us to assess the nature, size, and persistence of the shock before taking a decision on policy. Monetary policy cannot bring down energy prices. That's obvious to all of us. But we must identify when higher energy costs risk spilling over into broad-based inflation, be it through indirect effects or through second-round effects via wages and inflation expectations.
Principle number two: it requires us to focus on risks, not only the baseline. Because the effects of significant price shocks on inflation can be nonlinear, we need to work with scenarios and pay close attention to the early warning signs that the shock is embedding in broader inflation dynamics.
Principle number three: it gives us a graduated set of options on how to respond, which depend on the intensity and duration of the shock and how it propagates. Small, one-off, and short-lived supply shocks can be looked through. But as expected deviations from our inflation target grow larger and more persistent, the case for action becomes stronger.
So let's examine how we will be assessing the shock. And I'm going to do that with reference to what we experienced in 2022. Central banks and all of you have a long history of dealing with inflationary energy shocks, and over that time we have been able to build up a substantial body of evidence about when they risk spilling over into generalized inflation. In the euro area, the historical evidence suggests that the risk of broad pass-through from energy prices is the exception rather than the norm. When shocks are small in magnitude and short in duration, as has most often been the case, the inflation impact tends to largely stay within the energy compartment itself.
But two factors can change that picture. The first factor is the intensity and duration of the shock. Our research shows that the relationship between energy price shocks and inflation can be nonlinear. While small increases trigger no significant reaction in prices, larger shocks have disproportionately stronger effects. Disproportionately.
The second is the propagation of the shock, which depends on the macroeconomic environment in which it lands. Firms are more likely to be able to raise prices when demand is stronger. Workers are more likely to be able to bargain for higher wages when labor markets are tighter. And both phenomena are more likely when inflation is already high.
Our research confirms that pass-through is measurably stronger when capacity utilization is high and unemployment is low, and that wages feed into prices more forcefully when inflation is already elevated.
An additional point: how people have experienced inflation in the recent past also matters. Research shows that lived experiences of inflation can have lasting effects on how people form expectations, with recent salient episodes carrying disproportionate weight.
So remember when the energy shock hit in 21-22, several of these channels that I have just described were operating simultaneously. But there are factors today which point to a lesser pass-through. Let me take three. First, the initial shock has so far still been smaller. In 22, the shock was exceptionally large and persistent. Remember, even before the Russian invasion began, oil prices had increased three-fold between October 20 and March 22, and natural gas prices by even more as Russia gradually throttled supplies. Then Europe was effectively cut off from a supplier that had provided around 45% of its natural gas imports and forced to find new suppliers in a disorganized way. Remember, they had to compete in the global LNG market and build new import capacity.
Oil prices peaked at around $130 per barrel in March 22. A bit lower than what we have, but in a similar range. But gas prices surged to much higher levels than what we have seen so far: 340 euros per megawatt hour in August 22 versus around 60 euros today.
Second major difference: the macroeconomic background today is more benign. In 22, the economy was primed for pass-through. Europe was experiencing strong pent-up demand after the post-pandemic reopening. Supply chains were still disrupted after the pandemic. There were significant labor shortages. Headline inflation at the onset of the shock stood at around 5%. Our analysis confirms that this combination of factors exacerbated the inflationary effects. In particular, in the absence of demand pressures, the impact of supply-side shocks on inflation would have been considerably lower. There was a combination of supply and demand.
Today, the Euro area economy is in a moderate recovery phase without the pronounced demand-supply imbalances that characterized 2022. Headline inflation had been close to our target for almost a year. The unemployment rate is low by historical standards, yes, but we no longer face acute labor shortages in multiple sectors.
Third, the macroeconomic policies are less supportive. When the invasion began in 2022, monetary policy was highly accommodative with interest rates at minus 0.5% and the ECB still engaged in net asset purchases. The fiscal stance was also expansionary with an aggregate deficit of over 5%. Interest rates today are broadly at the neutral level, and the fiscal stance is neutral too, with an aggregate fiscal deficit of around 3%.
Well, I will contend that at the same time there are reasons for extreme vigilance. The International Energy Agency has described this as the largest supply disruption in the history of the global oil market. And with the attack on energy infrastructure, especially the Ras Laffan facility in Qatar last week, the likelihood of a quick normalization is now diminishing.
A further cliff edge, less talked about, is also approaching. Global oil reserves are being drawn down as we speak. And the last LNG tankers that loaded in the Gulf before the war started are now reaching their destinations, meaning the full impact of lost supply is only about to be felt. And if the shock does intensify, the response of firms and workers may be faster than last time.
We have a more recent memory of high inflation, which could affect how quickly costs are passed on to and compensation sought. During the last inflation surge, firms shifted to adjusting prices significantly more frequently. The share of consumer prices changing in any given month rose from around 8% to 12%. And as inflation came down, that frequency gradually returned to near normal levels. But the operational experience of changing and increasing prices remains.
That's on the corporate side. On the worker side, the initial response was relatively slow. After a long period of stability, it took time for employees and their representatives to seek inflation compensation. But research shows that as inflation rose, people began paying more attention to price developments, particularly when inflation was far away from target. Now, even though the 2022 shock was brought under control, that experience, both on the corporate side and on the worker side, has left its mark. An entire generation has now lived through its first episode of high inflation, and it may not be as slow to react this time around.
So we face a situation where if the current shock remains contained in energy markets, it may have a limited effect on broader inflation. But if it intensifies or persists, the pass-through could accelerate. So how can we calibrate policy under this level of uncertainty? There are two key elements. The first one is agility.
We have followed for some time a meeting-by-meeting, data-dependent approach without pre-committing to a particular rate path. And this was precisely because we did not want to have our hand tied in an environment where the outlook could change rapidly. In 2022, we were still bound by forward guidance on asset purchases and rates when the energy shock hit. That pre-commitment limited our flexibility to act. Now we are prepared, and we are prepared if appropriate to make changes to our policy at any meeting.
The second element of the agility is a focus on risk. Last year, we updated our monetary policy strategy with precisely the type of challenges we are facing in mind. Not because we were prescient, not because we knew what was going to happen, but we judged that we were moving into a world of more frequent supply shocks. From that walk in the park that I was expecting in late 2019, well, we have faced at least four major shocks since 2020, and structurally higher uncertainty.
So we decided in this environment that we needed to take into account not only the most likely path for inflation but also the risks and uncertainty surrounding the baseline. This emphasis on risks was embedded in our reaction function in July 2025. Given the range of possible outcomes we face today, scenarios are an especially valuable way to capture risks. They allow us to explore what could happen if key variables were to change. In particular, if the intensity, duration, and propagation of the shocks differ from our baseline assumption.
Our excellent ECB staff published—I was going to say under duress, but certainly under huge time pressure—two such scenarios last week. They did not just two scenarios, but they were the two that we thought would be appropriate for publication. These scenarios actually allow us to explore what could happen if variables were to change, and in particular, as I said, intensity, duration, propagation. Scenarios are not forecasts. Scenarios are just illustrations constructed, among other things, under a no-policy-change assumption at a particular time. And we will review them and update those scenario analyses regularly, and we will publish what we think is appropriate in due course.
Let me take you through the two scenarios that you referred to, Professor Wieland. The adverse scenario assumes that the shock intensifies, but its duration is relatively short, containing its propagation through the economy. Relative to the baseline, annual inflation moves almost 1 percentage point higher in 26, but falls back steeply by 28 as indirect and second-round effects are outweighed by a large energy-related base effect. Growth would be somewhat lower in 26 and 27 before recovering in 28.
The severe scenario assumes greater intensity, longer duration, and broader, more persistent propagation. Relative to the baseline, annual inflation would be significantly higher across the horizon by almost 3 percentage points in 2027 and would not return to target within the projection horizon. Growth would be notably weaker in 26 and 27 by almost 1 percentage point cumulatively before rebounding in 28.
These scenarios highlight a crucial feature of the current environment, which is the nonlinearity of the risks to inflation. As the shock grows in size and persistence, the response of prices and wages accelerates. The deviation from target widens disproportionately unless monetary policy steps in. Because of these nonlinearities, it is essential to identify as early as possible when the shock is at risk of broadening. And that means tracking closely the indicators that can signal ahead of time the size and timing of indirect and second-round effects.
You will hear a lot more about that from my colleague and friend, our chief economist, Philip Lane, in the next session. We did coordinate a little bit.
Now, of course, this will depend naturally on developments in commodity markets, because a sufficiently large shock will always spread beyond the energy component. But it will also depend on how the burden is shared. As a net energy importer, a spike in energy prices creates a terms-of-trade tax for us in the Euro area. But who is us? It's a shock that must be absorbed by a combination of workers, firms, and governments.
If firms increase their selling prices disproportionately, as we saw in 2022 early days, it could trigger an equivalent response from workers. What I have called at the time the tit-for-tat inflation. We will therefore watch very carefully firms' selling price expectations and micro evidence on price changes, as well as paying very close attention to our wage trackers and its movements.
We will also monitor the demand side, as the risks to growth are on the downside. A negative supply shock weighs on demand, which can reduce the ability of firms to pass on costs and of workers to bargain for higher wages. So far, consumer confidence has fallen more sharply in Europe than following the 9/11 attacks and the war in Kuwait in 1990, but not as steeply as following the unjustifiable Russian invasion of Ukraine.
If households increase precautionary savings as they budget for higher energy bills, it could point to a more limited pass-through. The fiscal response will also matter. Targeted government policies can help smooth the shock by reducing energy demand and compensating lower-income households, but broad-based and open-ended measures may add excessively to demand and strengthen the pass-through. I hope fiscal authorities have learned from the 22 episode as well.
So what is the appropriate policy response in the face of this supply shock? Our strategy also helps us define how to design that monetary policy response and to do it appropriately. Supply shocks are often presented as offering central banks a binary choice: either look through or react when inflation expectations are at risk of being de-anchored. But in reality, we can respond in a more graduated way.
In line with the medium-term orientation of our strategy, the appropriate response to a deviation of inflation from the target is context-specific and does not depend only on its origin—here a supply shock, no doubt—but also on its magnitude and persistence. And this points to three broad cases.
First case: if the energy shock is seen to be limited in size and short-lived, the classical prescription of looking through should apply. Transmission lags mean that a monetary policy response would arrive too late and risk being counterproductive.
Second case: if the shock gives rise to a large, though not too persistent, overshoot of our target, some measured adjustment of policy could be warranted. The optimal response to such a deviation is smaller when the cause is exogenous supply disruptions rather than strong demand. But it is not necessarily zero. Moreover, to leave such an overshoot entirely unaddressed could cause a communication risk. The public may find it difficult to understand a reaction function that actually doesn't react.
Third case: if we expect inflation to deviate significantly and persistently from target, the response must be appropriately forceful or persistent. Otherwise, self-reinforcing mechanisms would kick in and the risk of de-anchoring would become more acute. Our updated strategy is explicit on this point. Large sustained deviations call for forceful monetary policy action, shifting to persistence as the tightening cycle matures to prevent those deviations from becoming entrenched.
It is too early at this stage to say where on that spectrum we will need to be. Fortunately, we can assess the situation carefully because we are entering this shock from a good starting point. As I've said, we are well positioned. The policy stance is broadly neutral. Inflation has been on target for around a year, and longer-term expectations are well anchored.
So in the period ahead, incoming information will give us greater clarity on how the conflict is likely to evolve and how the economy is responding. We will monitor developments closely and set monetary policy as appropriate to deliver on our target.
So, as you reminded me, Professor Wieland, four years ago at this conference, as the energy shock from Russia's invasion of Ukraine was unfolding and gave us a chance to finally meet in person, I borrowed a line from Bertrand Russell, that the challenge we face is learning, and I quote, 'how to live without certainty and yet without being paralyzed by hesitation.' And those words capture our challenge today just as precisely as they did back in 2022.
But we are not in the same position as we were four years ago, nor was the conflict of the same nature. We have a strategy that is built for a world of higher uncertainty, with risks and scenarios at its core. We have a graduated set of options for responding, and we are starting from a better place should we need to act. And we will not act before we have sufficient information on the size and persistence of the shock and its propagation. But we will not be paralyzed by hesitation, because our commitment to delivering 2% inflation over the medium term is unconditional. I thank you very much for your attention.
