Inflation, interest rates and debts: an explosive cocktail

05.17.2022 2 min
Read the translation of my article published in the May 16, 2022 edition of Les Echos.

Should central banks have to finance public deficits linked to reindustrialisation, climate change or rearmament over the very long term, as opposed to the “we’ll do whatever it takes” approach that only lasted as long as the pandemic did? Does the debt not matter, in that case? Trapped by too many contradictory objectives, extremely accommodative monetary policies would then be prolonged, with interest rates remaining well below the growth rate and central banks’ balance sheets continuing to swell. No way! This is a convenient idea, but it’s a recipe for a very painful future. So, central banks are taking a different path.

Before the war, because inflation was more than only transitory, central banks had to exit quantitative easing and raise their interest rates gradually. But because of very high global debt levels and high valuations on financial and real estate markets, they toughened their tone cautiously when a strong surge in inflation occurred due to the war in Ukraine. An inflation that gets out of hand through indexation, even if imperfect, of prices to prices and wages to prices would indeed be a source of many evils. It would de facto lead to a significant inequality in income trends in real terms, both between households and between companies, as the ability to pass on price rises would be far from equal. Wage negotiations would become very contentious; price signals between producers, distributors and consumers would be unstable; loan contracts would lead to a disruption in the way interest rates are set between lenders and borrowers. Stable and low inflation is indeed essential for confidence among market participants, and therefore for an efficient economy. Today, faced with the threat of stagflation, central banks are faced with an even more delicate dilemma.

They must not undermine this weakening growth, but they have no choice other than to react if they have any hope of combating the major risk of uncontrolled inflation. \Therefore, if and when central banks normalise their monetary policy, they will have to do so with a great deal of clarity for the sake of their credibility, but also with great caution. They will have to test the effects on the financial markets, including government debt, at each stage. The ECB has an additional challenge: the eurozone is made up of countries with very divergent economic situations. At the same time, governments will have to show a credible fiscal trajectory, by making investments that promote potential and greener growth, but also by protecting the poorest from inflation… Structural reforms will also be essential, and more than ever, to facilitate growth and to participate in the solvency path – we are talking in particular about that of pensions in France. This narrow path is the only one possible.

If central banks were to perpetuate ad libitum a policy of financing public deficits and maintaining excessively low interest rates, serious financial crises due to the bursting of increasingly uncontrollable bubbles would cascade, structurally damaging growth. Inflation would sky-rocket to the detriment of the weakest and damaging the overall efficiency of the economy. And, sooner or later, confidence in money itself could be called into question. The flight from money would eventually lead to the collapse of the economy and the social order. Historical examples bear witness to this. Monetary policies will therefore tighten and interest rates will rise. There is little time left for highly indebted agents, public or private, to prepare for this.

Olivier Klein
CEO of BRED and Professor of Financial Macroeconomics and of Monetary Policy at HEC Business