Structural inflation has led central banks to end their accommodative monetary policy (quantitative easing) put in place since the crisis of subprime until the health crisis. The long expansionist bias of this policy can moreover be considered as a source of inflation.
In the United States, where inflation was 8.2% in October 2022, the Fed raised its rates six times between March and November 2022 to bring the main rate to 4%. At the same time, it reduced the size of its balance sheet by selling assets acquired during the health crisis, considering that with unemployment at 3.5%, the American economy has reached its natural unemployment rate (i.e. say its minimum level given the real economic forces).
In the euro zone, the ECB raised its rates three times between July and October 2022. The interest rate for commercial banks’ main refinancing operations is now set at 2.25%. The ECB also indicates that it is embarking on quantitative tightening (quantitative tightening), ie a reduction in the size of its balance sheet, to signify to the market the end of its policy of offering abundant liquidity.
The objective of these rate hikes, which will no doubt call for others in the months to come, is to fight against inflation and enable central banks to achieve their inflation target of 2% per year: the rise in rates should curb the lending activity of banks, encourage the formation of savings, thereby reducing the speed of circulation of money within economies and ultimately slowing the rise in prices. The achievement of this objective is not immediate. The ECB estimates that in the absence of a new shock, average inflation in the euro zone will drop from 8.1% in 2022 to 5.5% in 2023 then 2.3% in 2024.
It is a balancing act for central banks, because these rate hikes are not without risk. In fact, they risk slowing down economic growth already slowed down by the Russian-Ukrainian conflict, and therefore damaging the employment market, through the contraction of the credit market. Thus, the ECB foresees growth of 3.1% in 2022 then 0.9% in 2023. In the euro zone there is an additional problem of fragmentation of sovereign debt. With the prospect of quantitative tightening, the risk premiums of the countries of the euro zone, which were almost zero during the period of quantitative easingbecome positive and begin to diverge significantly, which raises the question of the stability of public debts.
Another risk of monetary tightening is its effectiveness. Indeed, by raising interest rates, central banks can effectively fight against inflation through demand. But these increases do not make it possible to loosen the constraints of supply or even to influence the world prices of raw materials to curb inflation by costs. Interest rate increases are, however, the only instrument available to central banks to achieve the objective of price stability. They testify to their firm will to fight inflation. In this way, they hope to anchor agents’ inflation expectations, in order to avoid a price-wage spiral, and therefore the prospect of self-sustaining inflation.
In effect, since the 1970s, the relationship between the growth rate of nominal wages and the unemployment rate, the Phillips curve has flattened considerably. The loss of bargaining power of employees reduces wage pressures, including in a tight labor market. Wages should therefore not increase at the rate of inflation, removing the risk of second-round effects. In France, for example, only the minimum wage is indexed to inflation. Its rise certainly spreads to other wages, but with an increasingly dampened effect as one moves up the wage scale. The lack of productivity gains in the euro zone is an additional factor in wage growth that is weaker than inflation.
In this inflationary context, what role for fiscal policy? It has no direct impact on the fight against rising prices, which is the prerogative of central banks. It must, however, support monetary policy to enhance its effectiveness within the framework of the policy mix. Fiscal measures can cushion the impact of the transitory component of the energy price shock on vulnerable households and viable businesses. But these measures must remain consistent with a non-expansionary fiscal stance because the continuation of an expansionary budgetary policy will be a source of inflation and will thwart the effectiveness of the restrictive monetary policy. At the same time, structural reforms must be implemented by States to develop the energy security of oil and gas importing countries. Massive investments are needed (EPR reactors in France, for example) to promote ecological transition, a source of long-term growth.