Is the end of historically low interest rates in sight? To counter high inflation, the Central bank of the United Kingdom raises its interest rates, following the announcement by the US Federal Reserve. The European Central Bank will not follow for the time being, although it will put an end to the coronavirus support next year.

Fighting high inflation by raising interest rates-or at least not. How do the central banks intend to respond to the high inflation rate, and what could be the consequences?

What is inflation?

Inflation is price rises. Within the euro area, inflation is now around 5%. This means that the prices of goods and services have risen by an average of 5% over the last year. Life is getting more expensive. If you pay 100 euros for a package of goods and services today, you only paid 95 euros for that same package last year.

What causes inflation?

How are the price increases caused? Today, that has a lot to do with the coronavirus pandemic. The rebound after the first coronavirus wave has been very strong, partly because central banks and governments have pumped a lot of money into the economy. Demand has increased enormously, with the result that demand for energy and raw materials has also increased sharply.

The other side is the supply side. It has been disrupted – again by the pandemic -: we see supply problems and long production chains, which sometimes force companies to close. The offer is stalled.

The combination of a surge in demand and a slowdown in supply has led to the current price increases.

Fighting inflation by raising interest rates: how does it work?

By raising interest rates, central banks are trying to reduce demand – consumption demand and investment demand. If the interest rate rises, the credit becomes more expensive and therefore less attractive. The rise in interest rates is therefore an attempt to reduce demand in order to gain control over price increases.

What have the central banks decided?

For the first time since the coronavirus pandemic, and rather unexpectedly, the Bank of England, the British central bank, has raised interest rates. The UK’s main interest rate was 0.1 percent-since March 2020, when the Bank of England stepped up to support the economy in the early days of the coronavirus pandemic-but is now going to 0.25 percent. It is the first rate increase since August 2018.

The interest rate increase should help to contain high inflation. It currently stands at 5.1%, the highest level in more than ten years. Over the next few months, it could reach 6%.

Earlier, the US Federal Reserve had already announced forecasts that perhaps three interest rate increases would be appropriate in the course of next year.

The European Central Bank will not follow for the time being, although it will put an end to the coronavirus support next year. The ECB’s interest rates are not affected. The main interest rate in the euro area has been at zero since March 2016.

Why do the differences exists?

Perceptions in the US and the UK on the one hand, and the euro area on the other, differ. The US and the UK are following school economists who believe that the inflation surge is permanent and will last long enough to persuade central banks to take action.

On the other hand, the European Central Bank, following on from another school of economists, assumes that inflation will be temporary and will be over fairly quickly. She does not think it is appropriate to perform today.

What are the consequences of intervention?

Intervention or non-intervention therefore depends on whether inflation is considered temporary or not. There are risks involved in both approaches, whether they are already taking action or not.

If the US is wrong, and inflation turns out to be temporary, then by putting the brakes on it has stifled economic recovery.

If, on the other hand, the ECB were to make a mistake in not taking action at the moment, when inflation would prove to be permanent, then there would be a risk of a wage-price spiral. In this scenario, price increases could eventually lead workers to demand higher wages, which in turn could lead to price increases. Falling into such a spiral is problematic because it is difficult to control and difficult to stop.