European Central Bank Executive Board member Isabel Schnabel has indicated that interest rates must continue to climb, citing upside inflation risks stemming from prolonged Middle East tensions and surprisingly robust euro-area economic performance. The German official warned that consumer price growth could exceed the 2% threshold for an "extended period" due to elevated energy costs, cautioning that waiting to act until these pressures transmit to wages would leave policymakers "behind the curve."

Speaking in an interview on Tuesday, Schnabel stated that at current policy rate levels, inflation is unlikely to return to target in the medium term, making further monetary tightening necessary. She emphasized that with aggregate demand remaining strong, preventing second-round effects early is critical, as delayed action could necessitate even more aggressive tightening.

Eurozone Growth Hits 14-Month High

The ECB stands as the first major central bank to raise borrowing costs in response to the Iran conflict, with officials designating next month's meeting as a pivotal moment for determining whether additional measures are required. Investors have nearly fully priced in a 25-basis-point hike, which would bring the deposit rate to 2.5%, with expectations of one more increase by spring 2027, potentially as early as December.

Schnabel noted that markets "appear to understand our reaction function quite well," though she refrained from specifying how much further borrowing costs might rise. Data released Tuesday showed Germany's second-quarter output grew more strongly than initial estimates, supporting her view of European economic resilience. After stalling in early 2026, the eurozone economy expanded 0.4% during the quarter.

The ECB official remarked that the economy continues to outperform expectations, with incoming data repeatedly delivering upside surprises. She pointed to fiscal policy, recovering defense spending, and the global artificial intelligence boom as primary drivers. Sentiment indicators suggest growth is gaining further momentum, leading her to assess risks to economic growth as slightly tilted to the upside compared to June staff projections.

July Inflation Accelerates Across Eurozone

Addressing inflation, which accelerated to 2.9% in July, Schnabel cautioned that energy price pressures beyond oil are becoming more persistent. She described natural gas developments as "particularly concerning" given low European storage levels, posing a substantial upside risk to inflation. The longer the conflict persists, the higher the risk and intensity of indirect and second-round effects, especially amid robust aggregate demand.

A key question remains whether rates need to rise to levels that restrain economic activity. ECB Chief Economist Philip Lane has indicated that 2.5% represents the upper bound of the range where borrowing costs exert a neutral impact. Schnabel concluded that the extent of further tightening will depend on incoming data.