Isabel Schnabel, one of the hawkish members of the executive board of the European Central Bank, has made the most direct assessment and a clear case for a further increase in ECB’s key interest rates for the upcoming monetary policy meeting, to be held in two weeks.
Speaking during a conference on Thursday, her message was clear: the ECB was navigating a tightrope. On one side lay the danger of letting inflation remain too high for too long, and on the other, the risk of pushing a fragile economy into a recession.
Schnabel noted that despite a year of monetary tightening, the economic landscape remained volatile, influenced by factors such as Russia’s war on Ukraine and the consequences of the pandemic.
She argued that a more restrictive monetary policy might be necessary to bring inflation back to the ECB’s 2% medium-term target.
Uncertain economic climate
According to Schnabel, the euro area had shown considerable resilience against several headwinds, including global conflicts and supply chain issues.
She stated that despite a discernible slowdown in economic growth, there were pockets of resistance, particularly in the labour market.
While there had been a steady deterioration in economic sentiment, especially in the manufacturing sector, Schnabel saw signs of improvement in consumer confidence. This suggested that a deep recession might not be imminent.
One of the most significant issues highlighted in Schnabel’s remarks was inflation.
Although headline inflation had reduced somewhat due to the unwinding of previous supply-side shocks, underlying price pressures remained high.
Domestic factors, rather than external ones, were now the main drivers of inflation. This created a compelling case for a more restrictive monetary policy to achieve the inflation target.
The Phillips curve and employment
Schnabel also pointed out the importance of understanding the Phillips curve, which represents the relationship between inflation and unemployment.
She observed that the current labour market was tight but revealed signs of a prospective weakening. This complex interaction between labour supply, demand and inflation complicated the central bank’s decisions on interest rates.
Given the high uncertainty, Schnabel supported a data-dependent approach to monetary policy, making adjustments meeting-by-meeting based on a wide range of inflationary risks. This required not just focusing on the most likely outcomes but considering the entire distribution of potential scenarios.
Climate-change related risks
Schnabel gave particular attention to the new challenges posed by climate change, such as extreme weather events affecting food prices.
She mentioned the El Niño event and the drying up of the Panama Canal as the latest examples of climate-related risks.
These factors added another layer of complexity to inflationary pressures, making the task of monetary policy even more challenging.
She emphasised that while a few food commodity prices had already increased sharply in recent months, most of the effects were likely to become apparent only in 2024.
The ECB’s upcoming meetings would be crucial, with the governing council carefully weighing all the relevant risks. If they assessed that the current policy stance was inconsistent with a timely return to the 2% inflation target, Schnabel suggested that a further increase in interest rates would be warranted.
She emphasised that under a data-dependent approach, there could be no commitment to a specific peak rate or a promise to hold rates at a certain level for an extended period.