NextFin News - In May, one of the European Central Bank's most dovish policymakers issued a warning that ran against the prevailing patience inside the Governing Council: high oil prices could force the ECB to raise interest rates further, and even a ceasefire might not cool energy costs enough to stand pat. Four months later, Alexander Demarco has been vindicated - and the ECB's dilemma has only sharpened. On September 10, the Governing Council delivered its second rate increase of 2026, lifting the deposit facility rate by 25 basis points to 2.50% as Brent crude climbed back above $100 a barrel and eurozone inflation accelerated to 3.3%. The rate rise was expected. What matters now is the harder question Demarco's warning raises: how far can a central bank tighten monetary policy into a supply shock before it breaks the economy it is trying to save?
The Warning That Aged Four Months in Four Lines
Demarco, governor of the Central Bank of Malta since January 2026 and a voting member of the ECB's Governing Council, is not an obvious hawk. In an interview published on May 11, he broke with fellow doves who had urged patience and more data, arguing that the case for looking through the oil shock was eroding.
"The prospects of looking through this shock appear to be fading now, given the prolongation of the conflict and the prospects of oil prices remaining higher for longer."
His reasoning went beyond the spot price of crude. Damage to energy infrastructure and the risk that shipping through the Strait of Hormuz would remain disrupted meant supply constraints were likely to linger - a structural problem that a temporary ceasefire would not automatically fix.
"The damage done to the infrastructure is likely to keep energy prices at a higher level than that prevailing before the conflict," Demarco said. "Supply constraints are likely to linger."
The sequence of events since has tracked his thesis closely. The ECB held its deposit facility rate at 2.00% on April 30 despite headline inflation already at 3%. It then raised rates by 25 basis points to 2.25% on June 11 - the first hike of 2026. By early July, with oil retreating toward pre-conflict levels, Demarco struck a more patient tone at a forum in Sintra, saying the central bank could "afford to wait for the next set of projections rather than risk hurting unnecessarily economic growth with another hasty rate hike." That pause lasted through July. Then energy prices turned again: Brent settled above $100 on July 23, dipped below $90 as a pause in hostilities appeared to hold, and by early September was back above the psychological mark at roughly $101, with US crude near $96.
The inflation data left the ECB with little room to wait. Eurostat's flash estimate showed annual headline inflation in the 20-nation bloc climbing to 3.3% in August from 2.9% in July, driven almost entirely by energy prices, which rose 14.3% year on year, up from 10.3%. On September 10, the Governing Council raised all three key rates by 25 basis points: the deposit facility to 2.50%, the main refinancing rate to 2.65%, and the marginal lending facility to 2.90%, effective September 16.
Demarco declined to predict how many hikes would be needed, leaving the Governing Council's guidance deliberately open.
"We are committed to setting monetary policy to ensure that inflation stabilizes at 2 percent in the medium term," he said. "This could require one rate hike. It could require more."
The Transmission Mechanism: How Oil Gets Inside Eurozone Inflation
The first-order channel is mechanical and fast. The eurozone is a large net energy importer, so a rise in the oil price translates directly into higher fuel, heating, and electricity costs for households and firms. That is the 14.3% energy inflation print in August - a direct pass-through of the commodity shock. But the reason Demarco's warning carried weight inside the Governing Council is the second-order channel: the risk that higher energy costs feed into wages, services prices, and medium-term inflation expectations. That is the difference between a one-off price-level shift and a persistent inflation problem.
What makes this shock structurally different from a typical commodity spike is the persistence of the supply disruption. The conflict that began on February 28, 2026, when the Strait of Hormuz was effectively closed, sent Brent up more than 40% in March alone - the sharpest monthly gain since August 1990 - and to $138 a barrel in early April, the highest since June 2022. Even after partial restoration of flows, the market is no longer pricing a quick return to normal. US officials have said a full clearing of the strait would take weeks, and forecasters at DBS Bank have pushed the timeline for full restoration of pre-war throughput to late in the first quarter or early in the second quarter of 2027. That is not a quarterly blip; it is a multi-quarter supply constraint.
The evidence that this is a structural shift in the oil market's baseline, rather than a cyclical spike, is in the forecast revisions. The US Energy Information Administration projects Brent falling from roughly $106 a barrel in May-June to $89 by the fourth quarter of 2026, implying a full-year 2026 average of $95 - dramatically above the $55 to $58 range that was the pre-conflict consensus. Goldman Sachs lifted its December 2026 Brent forecast to $85. In other words, even the base case for 2027 sits well above where the market was trading before the war. A cyclical spike mean-reverts to its prior level; a structural shock re-prices the entire curve. This one has re-priced it.
That persistence is precisely what central bankers fear. Demarco's point about infrastructure damage is the crux: if pipelines, terminals, and shipping lanes remain impaired, the supply curve has shifted left on a durable basis, and no amount of demand destruction from higher rates will bring the price back to $60 quickly. The ECB's own updated scenarios, released alongside the September decision, acknowledge a broad range of outcomes depending on the "intensity and duration" of the energy shock and its "indirect and second-round effects." The Governing Council revised its 2027 inflation forecast up to 2.5% and its 2028 forecast to 2.1%, while leaving the 2026 estimate at 3.0%.
The Policy Trap: Tightening Into a Supply Shock
Here lies the ECB's trap, and it is the second-order consequence that Demarco's warning set in motion. Raising interest rates cannot repair damaged oil infrastructure or reopen a mined shipping lane. It works only by crushing demand - slowing growth, raising unemployment, and forcing firms and workers to absorb rather than pass on higher costs. That is a blunt instrument when the problem is supply, and it carries a real risk of delivering a second hit to an already weak economy.
The counter-thesis inside and outside the Governing Council is serious and well-argued. Several doves, including Luis de Guindos, François Villeroy de Galhau, and Yannis Stournaras, have continued to call for restraint and more data. Holger Schmieding, chief economist at Berenberg, argued 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." Gabriel Makhlouf of the ECB warned on September 11 that further aggressive rate increases could harm economic growth. Outside the bank, Julian Howard of GAM Investments cautioned that rate-setters are "on the verge of policy mistake territory."
There is hard data on their side. Core inflation, which excludes energy, food, alcohol, and tobacco, actually eased to 2.4% in August from 2.5% in July. Services inflation - the ECB's preferred gauge of domestic price pressure - slowed to 3.0% from 3.3%. On a monthly basis, core prices rose just 0.2%. If second-round effects were already running hot, these numbers would not look this benign. The doves' case is that the ECB is fighting the last war - the 2022 episode, when it initially treated an energy surge as temporary and watched inflation climb above 10% - when the current data still show contained underlying pressure.
The hawks' answer, and Demarco's, is that waiting is the more dangerous asymmetry. Determined not to repeat the mistakes of 2022, he argued that policymakers must stop higher energy costs from feeding into broader inflation and medium-term expectations before those expectations unanchor.
"These things don't happen overnight," Demarco said.
That cuts both ways: inflation expectations take time to rise, but by the time they are visibly rising, they are expensive to bring down. The ECB's own projections show headline inflation remaining above the 2% target through 2027 and only approaching it in 2028. With headline inflation at 3.3% and the 2026 average projected at 3.0%, the bank is already behind the curve on its own definition of price stability.
The market has largely sided with the hawks, at least for the near term. Before the September meeting, market-implied probabilities put a 98% chance on a 25 basis point hike. Looking further out, money markets were pricing roughly 60 basis points of additional tightening by April 2027, with the December meeting showing a 55% probability of the deposit rate reaching 2.75%. That path assumes the oil shock persists but does not spiral - a narrow corridor between the doves' stagnation and the hawks' inflation.
The Bond Market's Second-Guessing
The transmission of the ECB's decision does not stop at the policy rate. It flows through the yield curve, the euro, and sovereign spreads - and each channel carries its own message. A higher deposit rate lifts short-term yields immediately, but long-term yields reflect what investors believe about growth as much as inflation. If the market reads the September hike as the start of a sustained campaign against energy-driven inflation, long-dated bund yields rise and the yield curve steepens, tightening financial conditions for mortgages and corporate debt. If investors instead believe the ECB is choking off growth, long yields fall and the curve flattens or inverts.
The euro adds a second channel. A widening interest-rate differential with the Federal Reserve tends to support the single currency, which is disinflationary in itself - cheaper imports offset some of the oil-driven price pressure. That is the ECB's best-case transmission: rates rise, the euro strengthens, and imported inflation falls without the full weight landing on domestic demand. But the offset is partial and slow, and it depends on the Fed's own path. If the Fed is cutting while the ECB is hiking, the differential narrows and the euro's help fades.
The third channel is the one the ECB watches most nervously: sovereign spreads. Higher rates weigh heaviest on the most indebted member states, and a disorderly widening of the gap between German bunds and peripheral bonds would threaten the very monetary transmission the bank relies on. The ECB's Transmission Protection Instrument stands ready to contain such disorderly dynamics, but it is a backstop, not a substitute for a coherent growth strategy - and Demarco's own assessment of that strategy was sober.
"Especially on common bonds, I'm not seeing that much progress in this direction," Demarco said. "Things move slowly in Europe."
Who Is Right, and What Would Prove It
The cyclical-versus-structural call is the fulcrum. If the oil shock proves cyclical - if a ceasefire holds, the strait is cleared, and Brent returns toward $70 by mid-2027 - then today's rate hikes will look like an overreaction that needlessly slowed a fragile recovery, and the doves will be vindicated. If the shock proves structural - if infrastructure damage and geopolitical risk keep Brent above $90 through 2027 - then the hawks are right that the ECB had no choice, and the question becomes how much higher rates must go.
The falsifying signal is concrete and observable. The hawkish case - that further tightening is needed to prevent second-round effects - breaks if core HICP stays at or below 2.5% and services inflation falls below 2.5% for two consecutive months while Brent retreats below $80. That combination would show that energy costs are not feeding through to domestic price-setting and that the supply shock is self-reversing. Conversely, the dovish case breaks if core inflation re-accelerates above 3% alongside oil above $110, which would signal that the second-round channel Demarco warned about has opened.
What Comes Next: Scenarios and Exposure
The base case is that the ECB takes one more 25 basis point hike - likely in October or December - to a deposit rate of 2.75%, then pauses to assess whether the September and October energy data have fed into wages. The euro area's growth upgrade to 0.9% for 2026 and 1.4% for 2027 gives the Governing Council some cover to keep tightening without immediately triggering a recession call. The ECB's baseline sees growth holding up better than feared, which is the precondition for a gradual, data-dependent tightening path rather than an emergency campaign.
The downside scenario is that the conflict widens, Brent spikes toward $120, and the ECB is forced into aggressive tightening that tips the bloc into recession - the outcome Demarco said was "a real risk" only if the crisis deepened enough to force fuel rationing, a point "we are not there" yet. The upside scenario is a durable ceasefire, rapid clearing of the Strait of Hormuz, and oil back toward $70, which would let the ECB pause after September and potentially pivot to cuts in 2027.
For investors, the asymmetry is clear. A higher-for-longer rate path supports the euro and benefits banks' net interest margins, but it exposes rate-sensitive sectors - real estate, utilities, and highly leveraged corporates - as well as the more indebted peripheral sovereigns whose borrowing costs rise with every 25 basis point move. Equities face a familiar headwind: higher discount rates compress valuations even as energy-driven cost pressures squeeze margins. The sectors that benefit - energy producers, defense, and shipping - are the ones already priced for conflict, while the sectors that suffer are priced for a soft landing that a prolonged oil shock makes harder to deliver.
The final judgment is uncomfortable but unavoidable: the ECB is not wrong to raise rates into this shock, but it cannot win with rates alone. Demarco was right that oil would force the bank's hand. The next four months will show whether he is also right that the hand has room to keep tightening - or whether the supply side of the economy breaks first.
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