By David Barwick – FRANKFURT (Econostream) – A European Central Bank interest rate hike next week is clearly justified by inflation around 3% and the assumptions underlying the ECB’s June projections, though the policy path beyond September remains uncertain, ECB Governing Council member Joachim Nagel said on Wednesday.

“Currently, inflation is not close to our medium-term target; it stands at around 3% rather than 2%,” Nagel, who heads the Bundesbank, told French daily Le Monde.

“And according to the June projections, inflation will return to 2% over the medium term only under the assumption of higher interest rates,” Nagel said.

Markets were pricing a more than 95% probability of an increase at the ECB’s September 10 meeting, he noted, adding: “I would say that the markets understand our reaction function quite well at this point.”

Nagel was considerably more circumspect about the policy path thereafter, citing volatile energy prices and financial markets and a high degree of uncertainty.

“Beyond this September meeting, however, I am cautious about giving any indication of what comes next,” he said. “But the meeting-by-meeting approach has served us well in the past and will certainly do so in the future.”

Nagel rejected the argument that the exogenous nature of the latest inflation shock weakened the case for tighter monetary policy, warning that prolonged above-target inflation increased the risk of second-round effects.

“My argument here is very simple: inflation is too high, and the probability of second-round effects increases when inflation remains elevated for an extended period,” he said.

He pointed in particular to next year’s wage negotiations, saying trade unions could demand larger pay increases to compensate if they saw inflation continuing to deviate from the ECB’s 2% target.

Nagel also played down concerns that higher rates would seriously undermine economic activity, saying the euro area had proved “rather resilient” in the face of geoeconomic headwinds.

“In Germany, but also in the euro area as a whole, second-quarter growth turned out stronger than expected,” he said. “In Germany, export numbers were pretty strong, and manufacturing orders are okay.”

Based on the first two quarters, Germany was on track for “roughly 1% growth this year,” Nagel said, describing that as “quite a bit better than our June forecast.”

The recent increase in global long-term bond yields nevertheless complicated the monetary policy environment, Nagel acknowledged.

“It definitely does not make the situation easier,” he said. “Market participants are now demanding higher yields globally because they are confronted with a lot of uncertainty.”

The Governing Council would take those developments into account, he said, while stressing that “[t]he best we can do is to focus on our job: ensuring price stability in the euro area.”

Nagel also backed the principle of limited common European borrowing for narrowly defined purposes such as defence, while rejecting eurobonds as a means of financing national budgets.

“As a tool to finance national budgets, I have never advocated for eurobonds – definitely not,” he said. But “[u]nder narrowly defined conditions, a safe asset should be targeted for a specific purpose, such as defense.”

Such common borrowing must not weaken national fiscal discipline, Nagel said.

“I am not advocating weaker fiscal discipline,” he said. “But when it comes to common goods defense is the most obvious area because every country in the European Union shares the same interest in living in a safe region that can defend itself.”