The lasting end of free money

02.03.2023 2 min
Read my column in the 3rd of February 2023 issue of Les Echos.

It’s understood. Inflation needs to be fought, and the central banks’ policy will contribute actively to this battle. But the financial markets anticipate that, when inflation returns to its target, the central banks will cut their interest rates again, and long-term rates will gradually return to low levels in anticipation – they are already doing so in part – thus referring to the last decade. Let’s look at why this will probably not be the case. The years 2010 to 2021 saw very low long-term rates for several combined reasons. We were in an extended phase of globalisation and technological revolution. This pushed prices downwards and did not easily allow for wage increases. Inflation was very low, leading to very low interest rates. And because the central banks rightly feared deflation, then were faced with inflation under their target, they dropped their key rates to zero or even to the negative territory, while initiating a “quantitative easing” policy, thus more or less taking control of long-term rates and risk premiums.

However, starting in 2016-2017, while growth normalised after the very serious crisis of 2007-2009 and loans regained good momentum, long-term rates settled at very (too) low levels, for a very long time (too long), admittedly with very (too) low inflation. Long-term rates notched below the growth rate, excluding periods of crisis or convalescence, triggering an increase in financial instability. This means permanent and unsustainable debt growth in the event of a significant rise in interest rates; public and private debt grew by more than 45 points of GDP in advanced countries and 60 in emerging countries between 2008 and 2021. And the development of bubbles in equities and real estate; residential real estate prices rose by more than 40% in advanced countries between 2008 and 2021 and 35% in emerging countries. In addition, risk premiums are too low.

The current rise in interest rates therefore corresponds to a normalisation as well as a fight against inflation. The inflation component was gradually lowered due to insufficient supply – which was partially dislocated by the impact of measures against contagion – and demand that rebounded sharply after the lockdowns. However, a few structural factors are likely to persist. The effects of a partial deglobalisation movement and the sustainable cost of the energy transition. Such as the partial indexation of wages and probably a better ability of employees in the future to negotiate the sharing of added value, which has become distorted over the last 30 years in favour of profits in the OECD (except in France and Italy in particular). Structural inflation is likely to be between 2% and 3%. Once inflation returns to these levels, and excluding the effects of the business cycle, normalised long-term rates will probably average at the potential growth rate, i.e. in the eurozone between 1% and 1.5%, to which the inflation rate should be added, i.e. 2-3%. Long-term rates at around 4% should become the norm again across cycles. They would not facilitate the development of financial cycles, which are moving from growth phases to euphoria phases, leading to gradual over-indebtedness and the creation of bubbles. This leads to violent financial and economic crises. Short-term rates may, however, rise and bite into inflation, then fall somewhat later.

We are most likely to see a lasting end to free money.

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