Preserving the European Central Bank’s (ECB) credibility has emerged as a compelling argument for an interest-rate increase next month, according to Governing Council member Yannis Stournaras. Speaking from Nicosia, Cyprus, where he is attending a meeting of European finance chiefs, Stournaras underscored the critical juncture facing the central bank as inflation prospects deteriorate.
Stournaras, who also heads the Greek central bank, articulated a stark choice for policymakers. He warned that without a peace deal between the US and Iran, inflation prospects are worsening, and euro-area consumers will inevitably begin to question the ECB’s resolve. “An interest-rate hike comes at a cost — for people, for employment — and that’s why I wish we didn’t have to do it,” Stournaras stated. “But if the situation continues and we don’t, it’s going to be problematic. For the credibility of the ECB and our reaction function, we will probably have to raise rates in June.”
Inflationary Pressures and Geopolitical Risks
The urgency for a rate hike is intrinsically linked to persistent inflationary pressures, exacerbated by geopolitical tensions. Stournaras specifically pointed to the absence of a peace deal between the US and Iran as a key factor contributing to worsening inflation prospects. This geopolitical backdrop has kept oil prices elevated, with the potential for further escalation should the Strait of Hormuz remain blocked.
Policymakers had already engaged in discussions about lifting borrowing costs at their previous meeting. Stournaras indicated that a rate hike would become unavoidable if the current conditions persist, particularly if oil prices remain high and price stability within the 21-nation euro zone continues to be threatened. He offered a conditional reprieve, noting, “If there is an agreement, we might see energy prices falling very, very quickly, and then rates may be able to stay where they are. But without an agreement they might move into another level and inflation will become steeper.”
Economic Indicators Signal Sticky Inflation Amid Weak Growth
The ECB’s own projections for consumer price gains are under review. In March, the central bank had predicted an average of 2.6% inflation for the current year. However, this projection is now expected to be revised upwards in June. Governing Council member Alexander Demarco, in a separate interview, corroborated this view, also highlighting signs of weakening growth momentum across the euro area.
Recent economic data paints a mixed picture, complicating the ECB’s policy decisions. Output in the first quarter increased by a mere 0.1%, while a survey of purchasing managers has recently signaled shrinking activity. Stournaras expressed significant concern over these developments. “I have the feeling inflation is sticky,” he remarked, voicing worries that inflation expectations could become unhinged. He added, “The fact that the PMI is so weak won’t help us much. There are so many rigidities in the economy.” These rigidities, combined with the anemic growth figures, suggest a challenging environment for monetary policy.
The Imperative of a ‘Reaction Function’
Stournaras emphasized that the memory of past inflation shocks weighs heavily on the ECB’s decision-making process, potentially compelling the central bank to act decisively. The risk, he argued, is not just about current price stability but about the long-term perception of the ECB’s commitment to its mandate.
“Everybody will wonder if we have an actual reaction function or if it’s just a theory that’s never applied,” Stournaras cautioned. This sentiment underscores the critical importance of demonstrating the ECB’s readiness to combat inflation, even if it entails economic costs. The coming weeks are therefore pivotal. Stournaras concluded that “The next three weeks will be very crucial, looking at the second-order effects,” indicating a period of intense scrutiny on economic data and market reactions as the ECB approaches its next policy meeting.
