Schnabel defends ECB rate rises as overlapping shocks threaten inflation

The European Central Bank’s interest rate increases reflect a worsening inflation outlook amid the Middle East conflict and a broader combination of economic shocks, Isabel Schnabel said in remarks published by the ECB. She argued that policymakers cannot simply disregard supply disruptions when their effects threaten to keep inflation above the bank’s 2% target over the medium term.

Since June, the Governing Council has increased its key interest rates by 50 basis points, taking the deposit facility rate from 2% to 2.5%, Schnabel said. Markets had largely anticipated the decisions, and their effects were passing smoothly into financing conditions. The adjustment also helped stabilise real bank lending rates, which had fallen as inflation expectations increased following the conflict.

Why supply shocks can require tighter policy

Schnabel rejected the argument that central banks should routinely overlook supply-driven inflation because higher borrowing costs cannot resolve the underlying disruption. While interest rates cannot restore disrupted supplies or reopen the Strait of Hormuz, policy still needs to address the consequences for inflation. Without a response, rising expected inflation can reduce real interest rates and stimulate demand, adding to the original price pressures.

The appropriate response depends on how a shock changes the projected inflation path, rather than simply whether it originates in supply or demand, she said. Strong demand can give companies more room to pass higher input costs to consumers. Restraining that demand can therefore limit the spread of an energy price shock into broader, more persistent inflation. Schnabel said President Christine Lagarde had rejected describing June’s increase as an insurance measure, presenting it instead as a response warranted by the inflation forecast.

The nature of a shock nevertheless affects how quickly inflation should return to target. Schnabel said policymakers can accept a slower adjustment to avoid a sharper decline in activity when inflation expectations remain firmly anchored. If those expectations become less secure, a stronger response may be necessary to prevent temporary price increases from becoming entrenched.

New pressures meet unfinished disinflation

Before the Middle East conflict, headline inflation had returned to target, wage growth was easing and underlying measures suggested a sustained return to 2%, Schnabel said. But domestic price pressures had not fully subsided: services inflation remained above 3%, with most components rising between 3% and 5%. Unit labour costs were increasing faster than their historical average, while households’ perceptions of inflation remained elevated.

Repeated inflation surges can change how households form expectations, workers negotiate pay and businesses set prices, she said. Other forces are also shaping the outlook. Rapid AI expansion is supporting investment and foreign demand while increasing the prices of critical inputs. The 2025 tariff shock is fragmenting and redirecting trade, while higher defence spending and Germany’s fiscal package are supporting demand.

Those forces have different, sometimes offsetting, effects, making it misleading to describe recent ECB decisions solely as a response to an adverse supply shock, Schnabel said. Staff projections combine assessments of their scale, persistence and transmission. The ECB’s policy framework, made more explicit in 2023, weighs the inflation outlook and its risks, underlying inflation and the transmission of monetary policy.

Future policy assessments will continue to draw on that combined picture. Schnabel said policy must adjust if the resulting outlook puts inflation above target over the medium term. She also stressed the uncertainty surrounding forecasts and said underlying inflation often provides the best guide to achieving a lasting return of headline inflation to target.