For more than a decade, global economic growth has benefitted from low interest rates as many economists prematurely declared that inflation was dead. Central bankers shifted their attention from ensuring price stability through orthodox monetary policy to promoting economic growth by providing ultra-cheap money to businesses and households.
The changing dynamics driving the economy are now forcing central banks to take a more hawkish view on the risks of stagflation – increasing inflation and sluggish economic growth.
The European Central Bank has paved the way for an interest rate hike of a quarter point in July and a potentially larger increase in September. Some economic observers argue that this move is long overdue. Others doubt whether this increase will be effective in dousing accelerating inflation.
The increase in interest rates may not be enough to mitigate the pain of stagflation but it will restore some sanity to
financial markets and the real economy. For too long, entrepreneurs and investors have underestimated the importance of pricing risk into their decisions. Businesses offloaded large amounts of debt on worried institutional investors and private investors seeking an adequate return on their investments. Too much credit risk shifted from banks to bond holders.
Some households exploited the low-interest rates charged for mortgages and consumer loans by borrowing significant amounts, often not understanding the impact that rising interest rates would have on their ability to repay their loans.
Many across Europe can now expect to face higher interest rates on their home and other personal loans. Any rises amounting to even one per cent would add up to €3,000 a year to the annual cost of servicing a €300,000 mortgage. Locally, there may not be an immediate effect on borrowers but they are far from immune in the longer term.
Financial markets are factoring in a 1.5 per cent increase in interest rates by the end of this year. This partly explains the slump in share and bond prices in the last few days. It is not good news for governments that need to finance or refinance their increasing debt.
There is no guarantee that increasing interest rates will be enough to slow the pace of inflation growth.
The disruption in supply chains due to COVID and the Ukraine war is still not resolved and the effects of introducing environmentally friendly economic policies remain uncertain.
The ECB’s tightening of monetary policy, including its commitment to buy distressed countries’ sovereign debt, could spark a debt crisis as financial markets fret at the prospect of the end of ultra-cheap money.
At the same time, euro area governments will have to gradually withdraw the generous support schemes for businesses introduced during the pandemic.
Central banks and governments now face a delicate balancing act between controlling inflation while not overreacting, as they did after the 2008 financial crisis, by increasing interest rates too fast. The risk of choking off economic growth in some European countries is genuine.
The first year of a new administration may be the best time to take measures to counter the more negative effects of stagflation. At the local level, while public finance indicators remain acceptable, great care is needed to prepare the public for the likely effects of sluggish economic growth and increasing living costs. No government can shield the country from the adverse impact of high inflation.
The future trajectory of economic growth and inflation remains uncertain. Policymakers must reinforce their commitment to managing public finances in a prudent way for the benefit of present and future generations of taxpayers.