A relative stability of the European single currency over the last twelve months has more to do with the dollar’s weakness than with an appropriate policy mix followed by the European Central Bank (ECB).

Based on the trade-weighted exchange rate during the last twelve months, the value of the euro has been moving withing a narrow range and is currently roughly where it was a year ago. But during that interval, the European currency rose 4 percent against the dollar.

Measured by that indicator, it does seem that the ECB has done a good job of maintaining the relative price of its currency, while the euro area and the US transacted a total of $1.1 trillion of bilateral trade in 2025 and in the first two months of this year.

The ECB’s accommodative monetary policy has also supported the euro area’s economic recovery during last year, with the GDP rising 1.4 percent after an average 0.6 percent growth in the previous two years.

And despite that fast and successful closing of the negative output gap, inflation ended up at an annual rate of 2 percent in the fourth quarter of 2025.

The party is over

But now comes the hard part. Soaring energy prices have already changed the environment that no longer justifies the euro area’s current settings of very accommodative credit conditions.

The euro area energy prices in March shot up 7 percent from the previous month. That raised energy prices at an annual rate of 5.1 percent – a huge reversal after a mildly declining pattern of energy costs over the previous twelve months.

Predictably, that energy shock triggered a 1.3 percent monthly increase of consumer prices for March, bringing them up to an annual rate of 2.6 percent.

The question is: Should the ECB now settle for the view that no action is required because those are “transitory and reversible” price events? Or should it do “something,” but not overreact?

One thing is clear: On current evidence, the ECB cannot maintain its current policy settings -- even if the Middle East crisis were to unwind in the weeks ahead.

The ECB’s zero or negative real policy interest rate was inappropriate well before the onset of sharply rising energy prices, because the euro area had high budget deficits, expanding public debt and rising wage and non-wage labor costs.

In fact, such a loose monetary policy was accommodating a hugely expansionary fiscal position of the euro area to support employment and household incomes.

The conceptual problem here is that the euro area is only a monetary union. Fiscal policies are sovereign domains that no member of the monetary union wants to relinquish.

Solidarity should be part of the union

Under such circumstances, the ECB should only calibrate its policy stance with respect to price inflation – a variable it can and should control.

Any attempt to disregard that policy rule would destabilize inflation expectations that drive the longer end of the yield curve, and it would only be a matter of time until the ECB is forced to raise its policy rates.

Taking German interest rates as an indicator of the euro area market behavior, one can see that since the beginning of March short term interest rates have risen by 50 basis points to 2.5 percent, while the ten-year bond yields increased by a similar amount to more than 3 percent.

The ECB should respond to inflation changes. Counting on declining energy prices is a fool’s errand.

Middle East will remain a permanent crisis. And so will the West’s war in Ukraine against Russia.

On the eastern front, Japan’s arms race is in full swing. Trouble is brewing in the Taiwan Strait. China’s contested maritime borders are flashpoints where the US is bound to intervene on the side of its treaty allies’ (Japan and the Philippines) territorial disputes with Beijing.

All that means that conflict driven energy prices are not a transitory and reversible event. Energy-induced supply shortages will lead to declining aggregate demand, rising unemployment and falling household incomes.

The ECB cannot accommodate such a flagrant failure of global governance.

But the ECB can advise the euro area member states to attenuate the impending recession with an appropriate fiscal stimulus by countries running low budget deficits, large trade surpluses and low inflation rates.

Germany, Italy and Netherlands meet those criteria. Taken together they account for more than half of the euro area economy. And that means they can help the rest of the area to adjust to higher energy costs without large losses of jobs and incomes.