ECB rates must rise; bank share volatility unsurprising, ECB's Nagel says

By Andy Bruce

EDINBURGH (Reuters) -The European Central Bank must continue to raise interest rates to fight inflation, Bundesbank President Joachim Nagel said on Friday, playing down another sell-off in bank shares as a natural extension of the recent market volatility.

The ECB has lifted rates at the fastest pace on record over the past year but recent turbulence on financial markets in the wake of prominent bank failures has raised doubts about its resolve to tighten policy further.

But Nagel made clear that a pause is not in order as inflation, seen averaging around 6% in Germany, the euro zone's biggest economy, will take too long to come back to the ECB's 2% target.

"Wage developments are likely to prolong the prevailing period of high inflation rates," Nagel said in a lecture in Edinburgh. "In other words: Inflation will become more persistent."

Bank shares tumbled again on Friday, led by a 12% drop in Deutsche Bank on worries that sector's worst problems since the 2008 financial crisis were not yet contained.

"I'm not so surprised that the markets are a little bit more volatile compared to before these events," Nagel said, declining to comment on Deutsche Bank. "In the weeks after such interesting events, it is often a bumpy road."

ECB policymakers have spent the past week arguing that euro zone banks are well capitalised and hold ample liquidity, so the volatility is merely exported contagion and not a symptom of domestic weakness.

LABOUR MARKET

The ECB also said that price and financial stability are not opposing goals and it has different tools to fight both.

For inflation, the key issue is the jobs market, which is so tight now that labour shortages are an obstacle to production and unions have greater bargaining power over wages, Nagel said.

Wage growth is already too high to be consistent with the ECB's 2% target and, while a wage-price spiral is not yet underway, second-round impacts from income growth will keep domestic price pressures high.

Firms are hoarding labour out of fear that hiring beyond the current economic dip will be too costly and the supply of labour is already shrinking in much of the 20-nation bloc, so structural tensions will remain, Nagel argued.

"It will be necessary to raise policy rates to sufficiently restrictive levels in order to bring inflation back down to 2% in a timely manner," Nagel said. "We should likewise keep policy rates sufficiently high for as long as necessary to ensure lasting price stability."

(Reporting by Andy BruceWriting by Balazs KoranyiEditing by Christina Fincher and Frances Kerry)