Europe's inflation scar is back, and it's changing how people behave

Euro zone inflation expectations are at risk of rising more quickly than in the past, and the European Central Bank must be prepared to tighten policy swiftly if signs of persistent price pressure emerge, ECB Governing Council member Dimitar Radev said.

The warning comes as surging energy costs driven by the Iran war have pushed inflation well above the ECB's 2% target, prompting an intensifying debate among policymakers about whether to act before higher prices become embedded across the broader economy.

Balance of risks has shifted

"The balance of risks has shifted in an unfavourable direction," Radev, who heads Bulgaria's central bank and is one of the ECB's newer Governing Council members, told Reuters in an interview in Sofia.

"The likelihood of a more adverse scenario has increased, particularly in light of the energy shock and the elevated level of uncertainty."

Radev was referring to the three economic scenarios — adverse, baseline and severe — published by the ECB last month.

While the baseline remains the central case, he said the probability of the adverse path had risen materially.

Memory of past inflation could accelerate expectations

A central concern is that consumers and businesses, who lived through runaway prices just four years ago following Russia's invasion of Ukraine, may adjust their expectations rapidly — demanding higher wages and prices and setting off a self-reinforcing inflation spiral that would prove costly to bring back under control.

"Recent inflation developments appear to have increased the responsiveness of expectations, meaning that pass-through from new shocks can occur more quickly than under normal conditions," Radev said.

His remarks echo those of several other ECB policymakers who have stopped short of explicitly calling for rate rises but have signalled the bank must be ready to act.

No second-round effects yet, but fragility persists

For now, inflation expectations remain anchored at the ECB's target and second-round effects are not yet visible in the data.

March's inflation reading showed a sharp jump in energy prices but suggested that services price pressures were easing.

However, Radev cautioned that the ECB cannot take a benign outcome for granted in such a fragile and fast-moving environment.

"If the shock persists and begins to affect wages, margins and expectations, the cost of inaction would increase," he said.

"In such a situation, acting in a timely manner would be the more prudent course."

April meeting and what the ECB is watching

Financial markets have priced in more than two ECB rate rises this year, with the first expected in June.

Radev said it was too early to say whether sufficient data would be available by the 30 April meeting to justify a rate decision, but added that enough information would be in hand to allow for a more concrete and structured policy discussion.

The ECB will be paying particular attention to measures of inflation expectations, underlying price figures, sentiment indicators, energy price developments and — above all — signals about the duration of the Iran war and its economic consequences.

Radev also flagged the risk that government subsidy programmes, if introduced to cushion consumers from energy costs, could add fuel to inflationary pressures rather than dampen them.

The euro zone's starting position is more favourable than in 2022, he noted, given that interest rates are already at a higher level and expectations remain anchored — but the window for complacency is narrow.