By David Barwick – FRANKFURT (Econostream) – European Central Bank Executive Board member Isabel Schnabel on Wednesday said further rate hikes would be needed from today’s perspective to return inflation to the ECB’s 2% target over the medium term.

Schnabel told German weekly Die Zeit that the size and timing of further measures would depend on the conflict in the Middle East, the economy and inflation.

“From today’s perspective, we will need to raise interest rates further in order to bring inflation back to our two percent target over the medium term,” she said.

The ceasefire in the Iran war and the fall in oil prices had improved the short-term outlook, but did not justify a less vigilant monetary policy stance, she said.

“Although the short-term situation now looks better than we had expected, the ceasefire is no reason for monetary policymakers to let their guard down,” she said.

Energy prices had fallen, but remained well above prewar levels, Schnabel said. Energy prices for deliveries in coming years remained elevated, she said.

The sustainability of the peace agreement was unclear, while it could take months for shipping through the Strait of Hormuz and global supply chains to normalize, she said.

Transport could remain more expensive because of higher insurance premiums for the Gulf region, energy infrastructure had been damaged, strategic oil reserves would need to be refilled, and European gas storage facilities still had to be filled before winter, she said.

“All of this affects energy prices, and uncertainty remains high,” she said.

Inflation developments would not depend only on energy prices, Schnabel said.

“The inflation data for May already show that the energy price shock has broadened,” she said.

Inflation for non-energy goods and services had already risen, likely at least partly because of the war, she said.

Goods directly affected by the blockade and energy prices, including diesel, aviation fuel and fertilizer, had reacted first, she said.

Surveys showed that producers of other goods were also planning to pass part of the sharp rise in production costs on to consumer prices, she said.

This increased the probability of second-round effects, especially stronger wage growth as a result of higher inflation, Schnabel said.

So far, there was still no indication that wage growth was accelerating or that people expected higher inflation in the long term, she said.

“But the memory of the high-inflation period is still fresh, so expectations may now respond more strongly to rising inflation,” she said.

The ECB’s latest 25bp rate hike was appropriate even after the ceasefire, Schnabel said.

“No, this rate decision was appropriate in all the scenarios we considered, including a milder scenario in which oil prices normalize rapidly,” she said.

The move was necessary to prevent medium-term elevated energy prices from leading to second-round effects and still more inflation, she said.

Without the hike, inflation would have remained above the ECB’s 2% target over the medium term, she said.

Asked to explain how higher interest rates reduced inflation, Schnabel said companies’ costs had risen significantly because of the energy price shock and that firms had to decide whether to absorb those costs or pass them on to customers.

“That decision depends on how strong demand is,” she said. “This is where monetary policy comes into play: by raising interest rates, we dampen demand. That leaves firms with less scope to increase prices.”

The current level of ECB interest rates was not yet restrictive, Schnabel said.

“Interest-rate increases dampen economic activity,” she said. “However, the increase in policy rates so far, by 0.25 percentage points, has been modest, and rates are not yet restrictive.”

Even after the pandemic, when the ECB raised interest rates by 4.5 percentage points, the economy proved resilient, she said.

The Eurozone economy had also shown relative resilience during the current energy shock, Schnabel said.

According to ECB projections, the loss of growth was not as large as might have been expected, she said.

This partly reflected the fact that the Iran war was being overlaid by the artificial intelligence boom, which was supporting the global economy, she said.

Government support in many countries was also cushioning the energy shock for households, while Germany was spending heavily on infrastructure renewal and defense, she said.

The now lower oil price could make it easier for companies to pass previous cost increases on to consumer prices because demand was likely to pick up more strongly again, she said.

“All this may fuel inflation over the medium term,” she said.

If government demand had an inflationary effect, the ECB would have to counteract it with monetary policy, Schnabel said.

This was why the ECB emphasized that government measures responding to the energy shock should be temporary, distort prices as little as possible and be targeted only at people or companies that really needed support, she said.

On Germany, Schnabel said the ECB welcomed the special fund for infrastructure and climate neutrality and the exemption of defense spending from the debt brake.

It now depended on efficient implementation and accompanying reforms, she said.

“At present, growth in Germany is primarily supported by the fiscal stimulus,” she said. “But spending more money is not enough, reforms are needed, too.”

Germany was a large part of the Eurozone economy, but its economy had stagnated since 2019, Schnabel said.

This was to a significant extent due to structural factors that reduced long-term growth, including demographics, lower competitiveness and the need to keep pace with artificial intelligence, she said.

“What does concern me is the low growth potential,” she said. “Without reforms, Germany's growth could fall towards zero, mainly because of demographics.”

Germany’s debt level was unobjectionable, Schnabel said.

The sustainability of public finances was an important issue, but lay in the realm of politics, she said.

“We are guided by our mandate of price stability,” she said.