The economy’s reaction is very strange when the central bank raises interest rates less than inflation

In order for monetary policy to exert a stabilising influence, when inflation varies, the central bank must normally move nominal interest rates more than inflation. If, for example, inflation rises, the real interest rate would then normally rise, curbing demand for goods and services and driving down inflation. But we are now seeing that central banks’ response (and expected response) to inflation is “soft”: nominal interest rates rise less than inflation. The economy then reacts in a very particular fashion: If the inflation results from a positive demand shock, this shock has a strong positive effect on production and inflation; If it results from a negative supply shock, this shock has a strong positive effect on inflation and has a positive effect on production (the inflation due to the negative supply shock drives down the real interest rate and therefore drives up demand for goods and services).