Ukraine crisis and inflation: what are the options for European central banks?

The escalating crisis in Ukraine poses a challenge for central banks, highlighting inflationary pressures associated with the transition away from carbon as China competes with Europe for access to Russian fossil gas.

Driven by concerns over supply disruptions, EU gas prices jumped following Russia’s official recognition of self-proclaimed republics in Donetsk and Luhansk. The increase comes on top of existing inflationary pressures exacerbated by restrictions in Russian exports. As a result, European central banks face tough choices as they seek to maintain price stability and develop their net-zero transition plans.

Russia has controlled the flow of gas to Europe

European gas prices have skyrocketed over the past year, rising over 500% and reaching over four times the historical norm due to increased demand as Europe recovers from Covid-19.

However, while Russia has honoured existing contracts it  has not moved to meet this extra demand and has at times even reduced supply. The resulting increase in fossil energy costs has contributed to rising inflation which has reached levels not seen in 30 years.

Russia could increase the flow of gas through existing pipelines by up to a third, International Energy Association executive director Fatih Birol told reporters last month. “In terms of European gas … we believe there are strong elements of the tightness in European gas markets due to Russia’s behaviour.” Birol’s analysis has been confirmed by the European Commission in its quarterly report on European gas markets.

China’s transition reduces Russian reliance on EU fossil gas revenue

As an alternative to its European market, Russia has been increasing exports to China which is expanding fossil gas use as part of its low carbon transition. Russia began work on a gas pipeline to China in 2014, shortly after its annexation of Crimea and the associated western sanctions.

Launched in late 2019, that pipeline is now being accompanied by a second, larger one. This new trade relationship was cemented earlier this month when Russian president Vladimir Putin and Chinese president Xi Jinping agreed a 30-year gas deal, to be settled in euros.

While speculative, the timing of Russia’s pivot to the Chinese gas market and the associated reduction in its dependence on Europe for gas revenues suggests a possible influence over its actions in Ukraine. Since China’s growing gas demand is related to its efforts to reduce carbon emissions, this could also be interpreted as the materialisation of a climate-related transition risk with implications for price and even geopolitical stability.

Gas price instability affects euro area growth

European Central Bank (ECB) board member Isabel Schnabel recently warned of such effects in a speech to the American Finance Association.

“While spikes in fossil energy prices are a common phenomenon… the roots of today’s shock are likely to go deeper,” she said. “Central banks will have to assess whether the green transition poses risks to price stability and to which extent deviations from their inflation target due to a rise in the contribution from energy to headline inflation are tolerable and consistent with their price stability mandates.”

The increase in European fossil gas prices also has implications for economic growth. Recent ECB analysis has found that significant increases in fossil gas prices dampen economic activity by reducing households’ real disposable income and purchasing power and by increasing the costs of industrial production. A 10% gas rationing shock on the EU corporate sector would reduce euro area gross value added by about 0.7%, the study found.

Analysts call for targeted ECB lending and asset purchases

In response to the current price instability, civil society analysts have pointed to investment in renewables and energy efficiency as measures central banks can take to address fossil energy inflation and insecurity.

“The Ukraine crisis forces the EU to urgently rethink its energy mix strategy and to drastically reduce its reliance on imported fossil fuels of all kinds,” said Positive Money Europe’s executive director Stanislas Jourdan. “The ECB can support this transition by deploying discount rates on its TLTRO refinancing operations, thus enabling banks to extend cheaper lending towards renewable energies investments and energy efficient home renovation.”

Jourdan also said the ECB should “legitimately offer its support” to EU governments which are protecting their sovereignty and strategic interests by working to support alternatives to fossil fuels, adding that improving the EU’s energy efficiency would also improve the ECB’s ability to fulfill its price stability mandate.

Sustainable Finance Lab director Rens van Tilburg warned that this “gasflation” is a special kind of inflation that will not respond to a general tightening of monetary policies, calling instead for a more targeted approach.

“The ECB should act upon the knowledge that fossil fuels are and will be a danger to price stability, and the best way to mitigate this risk is to accelerate the energy transition,” he told Green Central Banking. The ECB should not end all asset purchases, he said, but only those of the most energy intensive companies.

Tilburg also reiterated Jourdan’s call for targeted green lending. “Do not completely stop the TLTRO programme, but rather target it more specifically on lending for the energy transition,” he said. He also called for loans to insulate homes and offices, along with investments in clean energy and energy efficiency, as a way to reduce the energy bills of businesses and households.

The contrast between the price instability associated with fossil fuel dependence and the stability and security of alternatives is becoming increasingly clear, said Simon Youel, head of policy and advocacy at Positive Money UK. “If central banks want to meet their targets for price stability in the medium and long-term, the best thing they could be doing is directing more investment towards low-cost renewables and increasing energy efficiency.”