Market: Why are central banks raising interest rates to curb inflation?

(BFM Bourse) – In response to rising inflation, many central banks have raised interest rates in recent months. The ECB has just upped the ante by moving to a more significant rate hike for the first time since 2011 to combat record inflation in June. Why this almost generalized movement?

The ECB this week joined the race to hike rates in which many other central banks around the world are already joining, with a stronger-than-expected hike of 0.5 points, an 11-year high. Why accelerate rate hikes? Due to rising inflation: +8.6% in June in the eurozone, +9.4% in the UK, +9.1% in the US and sometimes even double digits in emerging markets like Brazil.

The ECB’s decision is still more of a symbolic nature

Almost everyone is concerned: According to the International Monetary Fund (IMF), 75% of the central banks monitored have raised interest rates in the last 12 months. The US Federal Reserve (Fed) has already revised rates up three times since January, from 0.25% to 1.75%, while the Bank of England (BoE) has stringed up five rate hikes from 0% to 1.25 since mid-December %. “There is a kind of panic associated with the rise in inflation,” stresses Gregory Claeys, an economist at the Bruegel Institute in Brussels.

‘They need to act quickly and be seen taking action to prevent inflationary expectations from becoming entrenched, meaning that people expect even more inflation’, which would lead to increases in prices and wages, adds Paola Subacchi, professor of inflation international economics at Queen Mary University of London.

Compared to other central banks, the ECB’s decision on Thursday is still more of a symbolic nature, as it has just closed the side of negative interest rates. As for the Bank of Japan, it stands out with interest rates still close to zero, even negative given inflation is “only” 2.3%, which is close to its targets. A decision that has drawn criticism in a country more accustomed to stagnant prices since the late 1990s.

What is the expected impact of a rate hike?

The rate hikes are aimed at containing an overheated economy by restricting access to credit for households and businesses. For Europe, this policy lasts “an average of 18 months, depending on the model,” says Gregory Claeys. It dampens demand but is much less effective against external shocks (energy, food) that are currently exacerbating inflation on the continent, he warns.

This is the limit of monetary policy and the reason why the major international organizations such as the IMF and the OECD are simultaneously urging states to provide temporary and targeted assistance to the populations affected by inflation.

Have Central Banks Waited Too Long?

Major central banks have long argued that inflation is cyclical and related to the economy’s strong recovery from the pandemic. But the wait has increased the risk of prolonged inflation, particularly by triggering the dreaded wage-price loop. “The ECB has probably waited longer than the others because it wanted to use its instrument to combat fragmentation” to protect the weakest countries in the euro zone from speculative attacks, explains Martin Wolburg, an economist at Generali Investment.

The lack of a coordinated response is also linked to parameters specific to each zone: the UK struggling with the impact of Brexit, the United States facing real job shortages and the eurozone, where “the characterization of inflation is less worrying than in the United States” because it is associated with a supply shock, estimates Amaury Goguel, associate professor at Skema Business School in Lille.

A recession in sight?

By raising interest rates too much, central banks also run the risk of slowing down the economy too much and leading it into a recession. Expecting a “bleak” economic outlook for the EU, the ECB thinks about avoiding a recession in 2022 and 2023. Too optimistic, according to Mr. Wolburg, for whom the euro zone will be “on the verge of a recession in the second half of the year”. .

n increased risk if the US plunges in and sweeps the global economy with it. “The indicators there are not catastrophic at the moment,” emphasizes Amaury Goguel, “Production, consumption and the labor market remain positive, even if the latter remains very tight. But if the recession hits, the domino effect would be real.”

However, the ECB’s wait-and-see attitude has also brought the euro to parity against the dollar, which improves the competitiveness of export companies, “and the first quarterly results (of European companies) underline this”, recalls Mr. Goguel.

(With AFP)