Bundesbank chief cautions ECB against aid to indebted states

FRANKFURT (Reuters) - Bundesbank chief Joachim Nagel cautioned the European Central Bank against trying to push down borrowing costs on the euro zone's southern rim and said focus should be on fighting off inflation, which may require more rate hikes than now projected.

The ECB last month pledged to buy more bonds from debt-laden countries like Italy and Spain to contain a widening spread between their borrowing costs and Germany's, arguing that unwarranted market moves jeopardised the success of monetary policy.

But Nagel said such help should only come in case of exceptional circumstances with narrowly defined conditions and duration so the ECB avoided signalling that it will always assure favourable financing conditions.

"I would thus caution against using monetary policy instruments to limit risk premia, as it is virtually impossible to establish for sure whether or not a widened spread is fundamentally justified," Nagel said in a speech.

The comments are Nagel's biggest public push-back against ECB policy since he took office in early 2022 and signal a potential revival of the divide between the ECB and its biggest shareholder that characterised the last decade.

While Nagel did not outright oppose the ECB's plans in his remarks, sources close to the discussion said he objected to the promise of new support at a June 15 emergency policy meeting.

If support is indeed granted, it must be "strictly temporary" and must keep pressure on countries to run sustainable fiscal policies and cut their debt levels, he added.

Help must also be justified solely on monetary policy grounds and bond purchases in the south must be neutralised so the overall policy stance is not affected.

Instead of fighting financial fragmentation, Nagel pointed to high inflation as the top concern and said that should be the ECB's focus because the rate hikes planned now may be insufficient.

The ECB plans its first rate increase in over a decade later this month before subsequent moves towards the "neutral" rate, which neither slows nor stimulates growth.

"Even that could potentially be insufficient to bring the medium-term price outlook in line with the 2% target," he said. "A restrictive monetary policy stance may be necessary to achieve this, at least temporarily."

At 8.6%, inflation is more than four times the ECB's target and even longer term expectations are drifting up, raising the risk that expectations become de-anchored as firms and households lose trust in the central bank's commitment to its objective.

"De-anchoring of inflation expectations has to be prevented no matter what," Nagel said. "Which now calls for resolute monetary policy action... the still very accommodative monetary policy stance should swiftly be abandoned."

The ECB plans another rate hike in September, which is set to be bigger than the 25-basis point increase in July, unless the inflation outlook improves.

(Reporting by Balazs Koranyi, editing by Ed Osmond)