Changing rates: how to find the right balance?

Despite an economic recovery hit hard by the war in Ukraine and its impact on energy prices, the European Central Bank is starting to raise rates. Inflation demands it, although finding the balance will not be easy.

Interest rates are all, in one way or another, guided by the behaviour of central banks. Other factors such as risk or capital supply and demand also play a role in defining the "general level of rates", but central bank monetary policy remains the most important anchor.

Most central banks have a mandate to ensure price stability by acting primarily through their policy rate, i.e. the rate at which they lend liquidity to the economy, via the markets (US) or banks (Eurozone). When inflation is deemed to be too high, a rate increase is supposed to slow down the economy. The mechanism is actually quite simple to understand: by making financing the economy more expensive, the central bank slows down consumption and investment, which in turn slows down aggregate demand in the economy. Faced with slowing demand, it is difficult for the supply side (producers) to continue to raise prices, which ultimately slows down inflation. Other mechanisms, such as the exchange rate or savings, work in the same direction. And conversely, when a central bank wants to stimulate activity to boost inflation, it will lower its rates to stimulate consumption and investment.

The current situation of the US economy is a good illustration of these mechanisms: economic activity remains solid, the labour market is creating jobs, demand is strong and inflation is slipping. As a result, the Fed (the US central bank) has started an aggressive process of raising its policy rate. As inflation remains very high and continues to rise, the Fed is likely to continue to do so in the coming months. That said, the first effects of the rate hikes are being felt, particularly in the real estate sector: tighter financing conditions are slowing down the US housing market. Other headwinds should gradually make themselves felt on the economy. It may seem paradoxical for a central bank to put the brakes on the economy in this way, but it is the only way to calm inflation.

The European Central Bank has also decided to raise its key rate. Inflation in the eurozone is over 8% and there is no sign that it will return to an acceptable level (close to 2%) in the immediate future. It must therefore act, as not doing so carries the risk of losing control over inflation for a long time. On the other hand, the ECB's decision, and those that will follow, are a little more delicate to take than in the United States. Indeed, European inflation is mostly imported inflation due to soaring energy prices. It is difficult for a central bank to combat this type of inflation. Moreover, aggregate demand in the economy is affected by the sharp rise in energy bills. It is clearly not as dynamic as what can be observed in the US. Rate hikes could therefore slow down demand that has already been damaged by the multiple shocks of the war in Ukraine, soaring gas prices and difficulties in supplying companies with components.

But doing nothing would be even worse. Raising rates at least gives an important signal that the central bank intends to regain control of inflation and wants to prevent imported inflation from leading to a long inflation spiral where ALL prices are constantly rising (such a phenomenon is already observed in some countries).

The challenge for the ECB will therefore be to find the right balance between the need to act on inflation and the desire not to destroy too much of the economic recovery that has already been badly tested by the shocks of 2022.

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