Monetary policy cannot do everything

Today, inflation has returned for the long term. Central banks must counter it. But an excessive rise in interest rates can trigger a recession, a hard landing. It can be too strongly calibrated, if we think that the transitory component of current inflation will weaken in the near future. Supply constraints have already begun to ease over time, barring the consequences of an escalation in the war. But an excessively slow rise in interest rates would lead to an increase in indexation. Reacting late, once inflation expectations are no longer anchored at a low level, would cost much more. Making deep recessions inevitable.

Interest rates too low for too long have globally led to very high debt ratios and bubbles in both equities and property. Rates must therefore be raised and quantitative easing policies gradually come to an end. But central banks are facing the risk of bursting bubbles, with impacts on growth, and the risk of insolvency for the most indebted companies and governments. This situation is therefore problematic for central banks, which must be very determined and very cautious. As a result, they have begun the normalisation of their policy and will go as far as its neutralisation. Including through a gradual exit from quantitative easing. But once this stage is reached, they will act according to the circumstances. If growth weakens sharply, if markets fall substantially, they will warn. The state of wage and price indexation, and therefore of the level of “structural” inflation, will then be scrutinised, in order to question the opportunity or danger of positioning interest rates above the neutral rate. If the inflationary regime were to strengthen further, they would very likely tighten their policy, both by raising their interest rates above the potential growth rate, and increasing quantitative tightening.

In this context, they will conduct monetary policies that are closely linked to data as they arise. While avoiding being dominated by fiscal issues and financial markets.

Meanwhile, governments have no choice but to have a credible medium-term solvency trajectory. An overly strict fiscal policy would destroy growth, but doing nothing when the level of indebtedness is high would undermine their credibility, which would be a very high risk in the short term.  They therefore need to put in place a policy of managing public finances without austerity, but which in reality is an exit from support policies. The unexpected, brutal and temporary pandemic is indeed to be differentiated from a possible change in inflation regime.

In addition, the investments needed to increase potential growth or green growth must be financed. However, this financing must be secured by more rational and efficient management of public spending, as well as by structural reforms. The latter are necessary to increase potential growth, i.e. sooner or later for a better ratio of public debt to GDP. They are also a means of combating inflation, the origin of which in Europe is more linked to a supply shock. And when the labour supply is very insufficient, job shortages can be alleviated by the reform of the labour market and the unemployment system, as by pension reform. In France, the employment rate of people over sixty is much lower than that of the rest of the eurozone.

The road is narrow. The essential fight against inflation, without too many economic and financial difficulties, requires a good combination of monetary policy and structural policies. Monetary policy can do a lot, but it cannot do everything on its own.

CEO of BRED and Professor of Financial Macroeconomics and of Monetary Policy at HEC Paris