How do inflation and interest rates interact?

In recent years, inflation rates in developed countries have been extremely low. With the temporary end of the COVID-19 pandemic, prices in Europe have risen noticeably and the inflation rate in the euro area is currently at 1.9% (source:
Eurostat). These dynamics are easy to explain: Aggregate demand (consumer demand and investment) increased significantly after the European economies began reopening after the pandemic-related lockdowns, assisted by the fiscal support provided by governments through stimulus packages.

Does the European Central Bank need to react? 

Many economists and central banks experts consider this increased inflation to be temporary and see no need for the European Central Bank (ECB) to act. The ECB has an inflation target of 2%, which is symmetrical, i.e., deviations from this target in either direction need to be counteracted. This inflation target is to be understood as medium-term, meaning that the ECB’s mandate does not require any interest rate reaction on the part of the monetary authority if the inflation rate exceeds or falls below the target value only temporarily. For this reason, forecasts of future price dynamics are particularly important for the implementation of monetary policy measures. As the ECB predicts an inflation rate of below 2% for next year, an interest rate reaction on the part of the central bank is not expected in the next few months.

Short-term versus long-term developments 

If the COVID-19 pandemic has long-term structural effects on individuals’ consumption behavior, inflation dynamics could change significantly in the future and deviate from projected levels. This makes a continuous and close monitoring of price developments using econometric models necessary to ensure an effective ECB response should inflationary pressures become too high. In this case, the current low interest rate gives the ECB plenty of slack to make any necessary interest rate increases.

Jesus Crespo Cuarema, Head of the Institute for Macroeconomics