The ECB’s Critics Are Misreading the Rate Rise

As expected, the European Central Bank decided to raise its monetary policy rates by 25 basis points. The decision by the Governing Council was unanimous, reflecting the consensus of all members of the Executive Board and the national central bank governors, including the six who do not take part in the vote under the rotation system that limits voting rights to 15 governors out of 21.

Nevertheless, various criticisms have been raised.

The arguments against the ECB’s move are mainly two. The first is that the rise in inflation, which climbed to 3.2 per cent in May, is due to external factors, mainly linked to higher commodity prices, which have not yet spread to the rest of the economy. According to this view, it would have been better to wait and see whether these so-called second-round effects materialise before raising interest rates.

The second argument is that monetary tightening risks further weakening the European economy, which is already suffering the repercussions of the blockade of the Strait of Hormuz.

Both criticisms are unfounded.

First of all, since monetary policy produces its effects with a delay of around 12 to 18 months, the central bank cannot wait for inflation to rise before taking its decisions. It must base them on its economic projections over a horizon of about a year and a half.

The ECB has just updated those projections. Inflation has been revised upwards, from 2.6 per cent to 3 per cent for 2026 and from 2 per cent to 2.3 per cent for next year. Under a so-called adverse scenario, involving a prolonged disruption to energy supplies, inflation would rise to an average of 3.3 per cent in 2026 and 3 per cent in 2027.

These are forecasts, and therefore obviously subject to margins of error. However, a comparison with similar exercises recently carried out by other international organisations, such as the OECD, the International Monetary Fund and the European Commission, does not reveal significant differences. All agree that inflation will not return to 2 per cent before 2028.

The even more important argument, though often ignored by commentators, is that these analyses are based on the assumption that, over the forecast period, interest rates are aligned with market expectations, as incorporated in the yield curve. In other words, the inflation projections for the next two years already incorporate the increase in interest rates anticipated by the market, of at least 50 basis points by the end of the summer. This means that if the central bank had decided not to raise rates, as markets expected, inflation would have turned out much higher than indicated in the projections.

The second criticism is that monetary policy is too restrictive in relation to the underlying condition of the European economy.

The central bank’s latest projections indicate growth of 0.8 per cent in 2026 and 1.2 per cent in 2027, with a downward revision of 0.1 percentage points for each year. The forecasts of other international organisations are not dissimilar. This means, first of all, that the slowdown in the European economy is considered temporary, even under the adverse scenario, and that already from 2027 growth should return to levels close to potential.

The even more relevant point is that, with average inflation forecast at 3 per cent and growth between 0.5 and 1 per cent, an interest rate level of 2.25 per cent cannot be considered restrictive.

An interest rate below expected inflation, in a phase of rising inflationary pressures, remains quite expansionary. And it carries the risk of accommodating those pressures. For this reason, in the absence of significant changes in the scenario, a further increase at the end of the summer, by another 25 basis points, appears necessary, to prevent monetary policy from becoming too expansionary.

This assessment is confirmed by developments in financial markets. In recent weeks, yields on 10-year government bonds have fallen, spreads have narrowed and the euro has depreciated against the dollar. These are all signs that monetary conditions remain relatively expansionary.

To assess the ECB’s decisions properly, it’s useful to get back to sound monetary theory. When inflation rises and nominal income is revised upwards, keeping interest rates unchanged means accommodating the demand for money, which sooner or later translates into higher inflation. In other words, the increase in rates is intended primarily to prevent monetary conditions from becoming too expansionary.

It’s hardly a tightening.

A previous version of this article was published in the Italian daily Il Foglio