(Bloomberg) --

The European Central Bank must not tighten monetary policy too early in response to an inflation spike driven by “purely temporary factors,” according to Executive Board member Fabio Panetta.

A premature withdrawal of stimulus would risk damaging the euro-area economy and curbing domestic demand, he said Wednesday. If current high inflation rates turn out to be more persistent, that could in fact lead to a situation where monetary policy needs to be eased further, he said.

That’s because the euro region is facing a “bad” bout of inflation, which occurs when negative supply shocks lift prices and depress economic activity, according to Panetta. “Good” inflation would be marked by robust demand and high employment, whereas “ugly” inflation occurs when expectations become de-anchored.

“The data suggest the current picture is dominated by a bout of ‘bad’ inflation generated outside the euro area, whereas we are far from seeing abnormally large domestic demand,” Panetta said. “Monetary policy should remain patient. A premature tightening would restrain spending before demand has returned to trend.” 

Panetta highlighted that 80% of current headline inflation reflects shocks generated abroad -- largely because the euro area is a net importer of energy and commodities. He said the region is lagging behind the global recovery in demand, and services consumption in particular is below pre-crisis levels.

While he said the current phase of “bad” inflation could become “ugly” if expectations were to become de-anchored and wages destabilized, he argued that the health of the labor market still hasn’t fully recovered. He also highlighted that the spell of high prices could risk weakening purchasing power.

“‘Bad inflation,’ acting as a ‘tax’ on demand, could ultimately move the economy further away from full capacity utilization, depressing medium-term underlying inflation,” Panetta said. “This might require an easing of monetary policy.”

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