ECB's Demarco signals rate hikes likely as oil shock persists

Alexander Demarco, governor of the Bank of Malta and one of the European Central Bank's more dovish rate-setters, has broken ranks with his cautious colleagues to warn that the latest oil shock will probably force the Governing Council to raise interest rates as early as its June 11 meeting. In an interview published on Monday, Demarco said the prospect of "looking through" the energy-price surge, the ECB's preferred phrase for tolerating a temporary supply shock without tightening, is fading because the conflict driving it shows no sign of ending quickly and the damage to infrastructure will keep prices elevated even if the shooting stops.

A second energy shock in four years

Europe is facing its second major energy crisis in four years. Russia's invasion of Ukraine in 2022 sent gas and oil prices soaring; the ECB initially treated that spike as transitory, only to watch higher energy costs cascade through the economy, lift inflation expectations, trigger wage demands and push euro-area inflation above 10%. Policymakers are determined not to repeat the error. At its April meeting the ECB left the key deposit rate unchanged at 2% even though headline inflation had jumped to 3%, arguing that medium-term projections still showed price pressures easing back toward the 2% target. But the statement accompanying the decision signalled a hike might come as early as June.

The current shock stems from the war involving Iran, which has disrupted tanker traffic through the Strait of Hormuz and damaged production and export infrastructure. Demarco stressed that a ceasefire alone would not restore normal supply. "The damage done to the infrastructure is likely to keep energy prices at a higher level than that prevailing before the conflict," he said. "Nor would a lasting ceasefire necessarily restore supply routes if, for instance, passage through the Strait of Hormuz remains risky. Supply constraints are likely to linger."

Why the doves are divided

Demarco's intervention is notable because he has historically aligned with the doves on the council, the governors and executive board members who favour waiting for more data before tightening. In recent days Luis de Guindos, the ECB's vice-president, François Villeroy de Galhau of the Bank of France and Yannis Stournaras of the Bank of Greece have all argued publicly for restraint, insisting that the economy is too weak to absorb higher borrowing costs and that the inflationary impact of the oil shock may yet prove temporary. Demarco agrees that policy must remain "data-dependent and meeting-by-meeting" but sees little reason for optimism about where the data are heading.

The division reflects a genuine analytical disagreement. The doves' case rests on two pillars: first, that the euro-area economy is already fragile, with growth near zero and unemployment edging up, which limits workers' ability to push through large wage increases; second, that companies facing weak demand will struggle to pass on higher energy costs, so the shock will compress margins rather than feed into consumer prices. Holger Schmieding, chief economist at Berenberg, wrote in an op-ed on Monday that "with growth weak and unemployment rising, workers are unlikely to be able to push through excessive wage demands. Companies, too, will struggle to pass on all additional costs to customers." Stefan Gerlach, chief economist at EFG Bank, echoed the argument for patience.

The credibility trap

Demarco's counter-argument is rooted in credibility. The ECB's 2% inflation target is a medium-term anchor; if households and firms come to believe the central bank will tolerate above-target inflation whenever a supply shock hits, expectations can de-anchor and the eventual cost of bringing inflation down rises sharply. "These things don't happen overnight," Demarco cautioned, noting there are no signs yet of expectations surging. But he warned that the window for pre-emptive action is narrow. He declined to specify how many hikes might be needed: "We are committed to setting monetary policy to ensure that inflation stabilizes at 2 percent in the medium term. This could require one rate hike. It could require more."

Financial markets have taken a more aggressive view. Money-market pricing currently implies three quarter-point increases by the end of 2026, a path that would lift the deposit rate to 2.75%. Most private-sector economists expect a milder cycle, typically one or two moves, reflecting the same growth concerns voiced by the doves. The gap between market pricing and the median forecast is itself a measure of the uncertainty surrounding the June decision.

Recession risk if crisis deepens

Demarco acknowledged the dilemma: raising rates in the face of a negative supply shock delivers a second blow to an already weak economy. The ECB's baseline forecast still avoids a recession, but he flagged a clear downside threshold. "If we arrive at that point, then there is, of course, a real risk of recession, but at this juncture we are not there," he said, referring to the possibility of fuel rationing. That conditional warning underscores how fine the line has become between tightening to preserve credibility and tightening enough to tip the economy into contraction.

Frustration with Europe's reform deficit

Beyond the immediate rate decision, Demarco echoed a broader frustration inside the Governing Council about Europe's failure to advance the structural reforms that would raise trend growth and make the economy more resilient to shocks. The capital markets union, revived as a priority by the Commission, remains stalled on the politically toxic issue of joint sovereign debt issuance. Fiscally conservative member states continue to block common bonds, and the requirement for unanimity in key policy areas makes progress glacial. "Especially on common bonds, I'm not seeing that much progress in this direction," Demarco said. "Things move slowly in Europe," he added, urging governments to streamline EU decision-making and abandon unanimity requirements where they paralyse action.

The link between monetary policy and structural reform is rarely acknowledged in public by central bankers, but it shapes the ECB's thinking. Low trend growth means the neutral real interest rate is low, which limits the room for rate cuts in a downturn and makes the economy more vulnerable to supply shocks. Without deeper capital markets, risk-sharing across the euro area remains incomplete, leaving national economies more exposed to asymmetric shocks. Demarco's willingness to voice this frustration publicly signals that the council's patience with political inaction is wearing thin.

What the data will show before June

The next three weeks will deliver a clutch of indicators that could sway the undecided. Flash May inflation for the euro area is due on May 30, followed by the June 5 economic bulletin and the final round of national CPI releases before the meeting. Wage data for the first quarter, published in late May, will show whether the 2024-25 collective bargaining rounds have embedded higher inflation expectations into pay settlements. The ECB's own consumer expectation survey, updated monthly, will reveal whether households' three-year-ahead inflation outlook has drifted above 2.5%. Any upside surprise on these fronts strengthens the hawks' case; downside surprises give the doves cover to wait.