The problem of stagflation: How should the European Central Bank respond to the increase in inflation?

Abstract

Inflation began to increase rapidly all around the world towards the end of 2021, and it remained elevated throughout 2022. Higher energy prices contributed significantly to the increase in inflation. However, core inflation, excluding the direct contribution of energy prices, was also significantly above the European Central Bank’s inflation target, which was partially due to the highly expansionary monetary policy implemented during the pandemic. Drawing on historical evidence, this article discusses how the European Central Bank should respond to the increase in inflation. Higher interest rates are necessary to counteract the Bank’s previous expansionary policy. However, when the economy faces significant headwinds, a monetary policy that is too tight may cause a severe recession. Lessons from earlier periods of inflation suggest that, from a long-term perspective, contractionary monetary policy is preferable despite the short-term pain. To limit the negative consequences, this contractionary policy should be coupled with supply-side reforms aimed at stimulating economic growth and increasing the resilience of the European economy.