European Central Bank Executive Board member Isabel Schnabel has cautioned that upside risks to inflation remain unresolved, given ongoing Middle East conflicts that keep energy costs elevated and a eurozone economy that continues to outperform expectations, making further interest rate increases necessary.

In an interview with Bloomberg on Tuesday, Schnabel stated that at current policy rate levels, inflation is unlikely to return to target within the medium term, adding that "further tightening will be necessary." She stressed that with resilient economic demand, second-round effects must be curbed early, warning that "delaying action would only force a more aggressive tightening later."

Markets have largely priced in a 25-basis-point rate hike at the ECB's next meeting, which would lift the deposit rate to 2.5%. Investors also anticipate an additional move by December 2026 at the earliest. Schnabel noted that markets "seem to understand our reaction function quite accurately," though she declined to offer specific guidance on the ultimate size of rate increases.

Unexpected Economic Resilience Brings Upside Risks

Supporting Schnabel's hawkish stance is a series of better-than-expected economic data. Figures released Tuesday showed Germany's second-quarter output grew more than initially estimated, while the broader eurozone expanded 0.4% quarter-on-quarter, the fastest pace in over a year, following near-stagnation in the first quarter.

Schnabel attributed this momentum to three key drivers: expansionary fiscal policy, accelerated defense spending, and the global artificial intelligence boom. "The economy keeps surprising to the upside, with new data consistently exceeding expectations," she said. "Confidence indicators point to further acceleration in growth. Compared with the ECB's June staff projections, I see growth risks as slightly tilted to the upside."

Inflation Pressures Widen While Energy Threats Persist

On the inflation front, eurozone inflation accelerated to 2.9% in July, and Schnabel expressed concern over the persistence of energy price pressures. She noted that energy pressures beyond oil prices are becoming stickier, with the natural gas situation "particularly worrying"—current gas storage levels in Europe are low, posing a substantial upside risk to inflation.

"The longer the conflict lasts, the higher the risk and intensity of indirect and second-round effects, especially when aggregate demand remains resilient," she said. Schnabel also emphasized that waiting until energy costs fully transmit to wages would leave policy "behind the curve." She expects consumer price growth to exceed the 2% target for "an extended period."

Whether Rates Must Enter Restrictive Territory Remains Key Question

Markets and policymakers are currently focused on a central question: whether rates need to rise to a "restrictive" level that dampens economic activity. According to Bloomberg, ECB Chief Economist Philip Lane has previously stated that 2.5% currently sits at the upper bound of the "neutral range," where rates neither stimulate nor restrain the economy.

Schnabel offered no clear signal on this matter, saying only that "the magnitude of further tightening will depend on incoming data." The ECB's next policy meeting is scheduled for next month, with officials already framing it as a critical juncture for assessing whether additional hikes are warranted.