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The European Central Bank must press ahead with raising interest rates and reducing its balance sheet to ensure inflation expectations don’t unanchor and demand a more aggressive policy response, according to Governing Council member Joachim Nagel.
Rate increases must continue after October, Nagel said on the sidelines of the International Monetary Fund’s annual meetings in Washington. Given tensions in energy markets there are “significant upside risks” to the inflation outlook, he said, adding that prices in Germany will likely rise at an annual pace above 7% next year.
“Further interest-rate hikes will be needed to bring the inflation rate back to 2% in the medium term — not just at the monetary policy meeting at the end of October,” said Nagel, who is also head of the Bundesbank. “The size of the interest-rate steps and how high we raise interest rates will be driven in each case by the current data and their importance for the inflation outlook.”
The ECB is widely expected to raise its deposit rate by three quarters of a point later this month, taking it to 1.5%. Traders bet the rate will reach 3% eventually.
“The ECB Governing Council must not let up too soon,” Nagel said, because “the longer inflation remains high, the greater the risk that longer-term inflation expectations will rise above the Eurosystem’s target.”
“If inflation expectations were to de-anchor to the upside, interest rates would have to rise even faster or higher and the macroeconomic costs of bringing inflation back down to the desired level would be higher as well,” he said. “This is a scenario that we on the ECB Governing Council absolutely want to prevent.”
Nagel argued that policy makers will also have to look into scaling back the ECB’s 5 trillion-euro ($4.9 trillion) portfolio of bond holdings, and said he’s committed to addressing this step in the Governing Council “in a timely manner.”
Turning to the German economy, Nagel said economic output could decline “significantly” in the fourth quarter and the first three months of 2023. The IMF’s latest projections foresee a contraction of 0.3% next year.