By Marta Vilar – MADRID (Econostream) – European Central Bank Governing Council member Olli Rehn said on Tuesday that rising long-term interest rates were hampering economic activity and holding back inflation, highlighting the tightening of financial conditions.

“The recent rise in long-term interest rates is dampening growth and slowing inflation,” Rehn, who heads the Bank of Finland, said in a speech to a Finnish parliamentary committee.

He said the increase in long-term borrowing costs reflected a combination of inflation expectations, heightened uncertainty and growing competition for capital, as governments and private companies seek financing for their investment needs.

In particular, he pointed to substantial borrowing requirements from governments running large fiscal deficits and increasing demand for financing from the private sector, especially companies investing in artificial intelligence.

“The increased demand for capital has driven up its price,” he said.

These developments were also affecting financing conditions in the euro area, with higher market interest rates and interest rate expectations pushing up bank lending rates for households and businesses.

“Although loan stocks have continued to grow in the euro area in recent months, tightening financial conditions may start to slow down borrowing and thus economic growth in the future,” Rehn said.

Rehn stressed that future interest rate decisions would depend on whether the recent energy-driven inflation shock began to generate broader price pressures across the euro area economy.

“From now on, the ECB Governing Council's monetary policy decisions will therefore depend on whether we see broader effects on inflation,” he said. “Although we have not seen them so far, we must remain vigilant, as they may emerge gradually.”

He noted that the recent acceleration in euro area inflation remained largely concentrated in energy-related products, with little evidence that higher prices had spread more widely.

Rehn also highlighted important differences between the current inflation shock and the energy crisis that followed Russia's invasion of Ukraine in 2022.

Unlike then, economic momentum remained relatively subdued, despite recent positive surprises, while demand for labour had been weak for several years and the labour market was no longer particularly tight.

Wage growth had also remained moderate and slowed further, suggesting that second-round inflationary effects had yet to materialize, he said.

“A return to the ‘old normal’ in energy markets seems increasingly unlikely in the current situation,” he said, adding that supplies of fossil fuels and certain critical raw materials could remain constrained for the foreseeable future.

Rehn reiterated that the ECB would continue to make monetary policy decisions on a meeting-by-meeting basis, taking into account the inflation outlook, underlying inflation dynamics and the strength of monetary policy transmission.

“I find this approach particularly justified in the current highly uncertain situation,” he said.

Despite the challenges posed by higher energy prices and tighter financial conditions, Rehn noted that the euro area economy had performed better than expected, supported by stronger private consumption, defense and infrastructure investment, and expanding AI-related activity.

However, he cautioned that a further prolongation or expansion of the Middle East conflict remained a significant downside risk to growth.