On June 9 last year, the European Central Bank (ECB) announced that it would raise interest rates by 0.25 points and then by 0.25 or 0.5 points for the first time in more than a decade, starting next July . in September.
This decision was motivated in particular by the rate of price increases, accelerated by supply difficulties and energy price hikes accelerated by the war in Ukraine. The inflation rate reached 8.1% in May 2022, compared with 7.4% in April (year-on-year) in the euro area.
“The Governing Council will ensure that inflation returns to 2% in the medium term”, the target set by its mandate, which ECB President Christine Lagarde also repeatedly underlined when announcing this historic increase.
Same trend in the United States, but with a bit of a lead: The US Federal Reserve (Fed) is preparing for the third interest rate hike in a few weeks on Wednesday and hints that the movement could accelerate. Again, this increase would come after the release of figures showing an acceleration in price increases with a new inflation rate of 8.6% over a year (and 1.0% over a month), a 40-year record.
After inflation had been viewed as temporary for a long time, on March 16, 2022, the Fed increased its key interest rates for the first time since 2018, in particular to cushion the rise in food and energy prices. So far, these various rate hikes haven’t stopped the labels from waltzing.
One might surmise that this policy will yield long-term results. Yes, but… There is also a psychological factor to inflation, which is often seen as a kind of self-fulfilling prophecy. When economic agents believe that the cost of living will rise, they adjust their behavior. Companies raise their prices and workers demand better wages. This cycle can increase inflation. Because of this, Fed officials approved their first rate hike while signaling their willingness to taper the rate cut to dampen future expectations.
The European Central Bank’s strategy has been to combine two approaches – concrete action on interest rates and hints at longer-term direction – hoping to work on traditional leverage as well as anticipation. This should have the potential to slow the stock market rally, narrow credit spreads, tighten credit spread conditions, dampen house prices and ultimately dampen demand.
However, this reaction should be treated with caution, especially considering the period of stagflation in the late 1970s and early 1980s, when Paul Volcker, then President of the Fed, decided to raise the federal funds rate to almost 20% in the face of rising prices and plunge the American economy into recession before the inflationary beast is tamed.
In recent weeks, economists like Laurence Summers have warned in The Conversation of the risk that this monetary policy could disrupt the post-Covid recovery. But do central banks still have a choice?
Read more: US: History shows that Fed rate hikes will not be enough to avert a recession
In theory, to control inflation, the central bank can react either to its policy rate, which is currently chosen on either side of the Atlantic, even if the rate of increase differs, or to the amount of money it issues. It is very difficult to use these two tools at the same time. In fact, every change in prices leads to a change in the money supply and vice versa.
Raising their key interest rates reduces the liquidity available to the poorest sections of the population for financial loans and mortgages. Ultimately, these decisions have a negative impact on employment. Higher interest rates are also discouraging private investment, especially as household, corporate and government debt, albeit gradually declining, remains high.
However, if the central bank does not raise interest rates and let inflation slip, food, energy and housing prices will rise, leading to a crisis in living standards that hits the poorest hardest. So the whole question is whether the price increase will be quickly and efficiently offset by a corresponding wage increase. That’s the whole dilemma.
Read more: Let inflation slide or stall the recovery, the dilemma for central bankers
When it comes to money issuance, the central banks’ second lever, it seems difficult to go any further than during the crisis: the growth rate of the money supply in the euro zone (year-on-year) had more than doubled at the end of 2020 compared to 2019 (5% to 11 %) to fall back to 7% by the end of 2021. In the United States, this rate has quintupled at the same time (from 5% to 25%). slightly below 15% by the end of 2021. A sudden fall in the money supply can have very unfortunate consequences for financial stability.
A first turnaround in the United States
As the US Federal Reserve (Fed) continued to encourage economic growth, the United States emerged from the pandemic. After peaking at 14.7% in April 2020, the country’s unemployment rate fell to 6.0% just 12 months later. As a result, promoting economic growth during this period began to cause price instability.
So the US economy has managed not to slide into recession, but money supply growth may have contributed to inflation. So the idea would be that by reducing money issuance, we would go a long way towards curbing price expansion.
However, it’s not that simple. Indeed, the tightness of bank liquidity is stimulating excessive tightening behavior in the United States. The recessionary factors (sluggish business climate, corporate destocking, public divestitures, etc.) are starting to show up and GDP has already contracted by 1.4% in the first quarter of 2022.
As for Europe, the continent is now portrayed as the political area most at risk from the consequences of inflation. However, the ECB’s reaction to an interest rate hike seems later and hesitant (even the director of the Deutsche Bundesbank, historically associated with the fight against inflation to preserve the pensions of German savers, seems more reserved than his colleague from the USA fear of a recession?)
The current inflationary context differs from the American “peoples moment” of the 1970s and 1980s. Inflation was primarily cost-driven in the 1970s, while it is demand-driven now. Anti-inflationary policies therefore need to be adjusted to lower inflation, protect purchasing power or even review energy balances, but without triggering new economic recessions. Hence the dilemma. As such, a combination of monetary tightening and fiscal restraint could now be the preferred policy stance on both sides of the Atlantic, at the risk of the economy sliding into recession. Needless to say, there aren’t many left…
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