Inflation is lower, but still too high

Continuing to increase interest rates while the inflation is declining might seem unnecessary. However, the Professor argues that raising the interest rates is still important.

Core inflation

Firstly, he argues that the quick decline in inflation is a consequence of the strong decline in energy prices. But, as the Professor points out, the core inflation is still rising and currently on and about 7%. Core inflation is the inflation corrected for the volatile energy prices. What’s more, the ECB is expecting the inflation to remain above the target-inflation of 2% until at least 2025.

Real and nominal interest rates

Secondly, Arnold notes that we should look at real interest rates (nominal interest rate corrected for inflation) rather than nominal interest rates. He explains that for consumers and businesses, real interest rates are decisive, not nominal interest. One of the basic principles of economic theory is that the real interest rate should rise to slow down the economy and bring a halt to rising inflation. However, on balance, the real interest rate has fallen since the ECB’s interest rate rose less than the core inflation. Hence, this basic principle is currently not respected.

Monetary and fiscal policy

Voices have risen claiming that raising the interest rates will deteriorate the financial stability in countries with high deficit. Although Arnold acknowledges this possibility, he claims that the solution to this problem lies primarily with a healthy fiscal policy in those countries. He stresses that the ECB should not be distracted while focusing on its main policy of reducing inflation.

The Professor concludes that we should not declare victory on our battle against inflation yet. The real interest rate is low, and governments continue to have deficits. With such a loose fiscal policy and too lax monetary policy, it will be difficult to bring the core inflation down quickly.