Philip Lane said in London on Wednesday that the effects of the Iran shock may be more contained than in 2022, but stronger and faster than historical averages. He also said that the current energy shock is unfolding in a less demand-supportive environment, based on firm-side and news-based indicators.

He said higher selling price expectations suggest that input cost pressures will feed into higher output prices in the coming months. He referred to the risk of an overshoot and said its size and persistence would shape the policy response.

Lane said a mid-size but not-too-persistent overshoot could warrant a measured adjustment. He said that if the overshoot is larger and more persistent, the response would need to be more forceful or more persistent.

He said demand destruction channels would limit the required adjustment in the monetary stance, while fiscal expansion would work in the other direction. He also said the optimal response might be smaller for an exogenous supply disruption than for a demand shock.

Given the recent shock from events in Iran, we are seeing energy input costs rise sharply, which will likely translate into higher consumer prices in the coming months. We saw Brent crude futures jump over 20% in late April, now trading above $110 a barrel, a level not seen since late 2024. The latest flash estimate for Eurozone inflation in April already reflects this, climbing to 3.1% and reversing the cooling trend we had gotten used to.

This situation puts the European Central Bank in a difficult position, and we should expect its response to be quicker and stronger than historical averages, even if more contained than the 2022 crisis. The key variable is persistence; a “measured adjustment” in rates could come soon, but a “forceful” response is on the table if high energy prices stick around. This suggests a hawkish tilt, meaning the days of pricing in rate cuts for late 2026 are likely over for now.

For traders, this points toward pricing in a higher probability of at least one rate hike by the ECB’s September meeting. We should look at derivatives that benefit from rising short-term interest rates, such as selling Euribor futures contracts or entering pay-fixed interest rate swaps. The market may be underestimating the ECB’s willingness to act, creating an opportunity for those positioned for a more aggressive policy path.

Volatility is another key area to watch, as the central bank’s path is uncertain. The tension between fighting inflation and avoiding a recession, especially with Q1 2026 GDP growth at a mere 0.1%, creates a ripe environment for price swings. We should consider buying volatility through options on bond futures or currency pairs like the EUR/USD, as policy surprises are now more likely.

Looking back to the energy crisis of 2022, we saw how rapidly the ECB pivoted from a dovish to a hawkish stance once inflation became unanchored. While today’s economic environment is weaker, suggesting less underlying demand, the memory of that policy shift will make officials eager to maintain credibility. This time, the response will be swift to prevent a repeat of inflation expectations getting out of control.

However, we must also monitor for signs of demand destruction, which could limit how far the ECB needs to go. High energy prices may curb consumer spending and industrial activity on their own, essentially doing some of the central bank’s work for it. If upcoming retail sales and PMI data show a significant slowdown, the ECB might lean towards a smaller rate adjustment, which would challenge overly aggressive hawkish positions.