Rehn: Geopolitics casts shadow on Europe's economic outlook

Rehn noted that the Iran war acts as a stagflationary shock, weakening growth prospects while accelerating inflation, at least in the short term.

He clarified this does not signal a return to 1970s stagflation but a similar shock dynamic.

The ECB and Bank of Finland are using alternative scenarios alongside a baseline forecast to assess possible futures.

Developments currently lean towards an adverse scenario, particularly concerning oil prices.

Rehn outlined three possible paths for the energy shock: temporary, significant but without second-round effects, or prolonged with broad inflationary pressures.

He emphasized that monetary policy must respond decisively if inflation expectations become de-anchored or wage-setting adjusts to persistently higher inflation.

New Eurosystem staff projections are expected next week, providing fresh data for a deeper assessment of the inflation and growth outlook.

Euro area medium-term inflation expectations, derived from swaps, remain anchored near the ECB's 2 percent target, ranging from 2.02 percent to 2.16 percent.

This stability persists despite temporary upticks following the conflict's outbreak.

Rehn contrasted this with the United States, where inflation expectations have not mirrored the recent decline seen in the euro area, partly due to stronger demand and the US being an oil-exporting country.

Research by the Bank of Finland demonstrates that geopolitical shocks have complex and unique effects on the economy, meaning similar energy price increases can yield vastly different inflation outcomes depending on prevailing economic conditions.

He compared the current situation to 2022 (strong demand, supportive policy) and 2011 (weak economy, sovereign debt crisis), concluding that today's environment is different, with weaker growth and less tight labor markets.

The lesson is to distinguish between temporary relative-price shocks and persistent inflation processes, aligning with the ECB's medium-term orientation and symmetry in monetary policy.