The signal of the economic activity degradation and even in some cases, of a recession, as in Germany, and of the slowing of inflation, have not dissuaded the Central Banks, apart from China, from going on with increasing their rates or with announcing future increases. The chairman of the Federal Reserve in Washington has not proceeded to an eleventh rise in June but he gave to understand that other increases will occur before the year end. The European Central Bank, to the opposite, has proceeded July 15th to an eighth increase of 25 basis points and its chairman, Christine Lagarde, has indicated that it was not going to be the last one. The United Kingdom Central Bank has brought its one in June to 5% with a 50 basis points increase. And in Japan, yet facing a very low inflation and a stagnating growth for two decades, the Central Bank, which had proceeded to a small increase at the end of 2022, has given to understand that its rates could further rebound.
Among the major economies, China is an exception. The one and five-years bonds rates will slowly fall, going respectively from 3.65 to 3.55% and from 4.3 to 4.2%. but the country has a very low inflation, around 2%. Its real rates, unlike the Western economies, remain positive. This measure is assigned to reduce the risks which currently affect the real estate sector. Several important property developers had launched programs with a heavy indebtedness and are confronted with the stoppage of the works, which provokes the discontent of the families who too indebted themselves in order to become home owners.
The Central Banks justify their action in quoting their implicit or explicit mandates, i.e. to make inflation coming back to a level near but under 2%. The rates increase, through the slowing of the demand, whatever it comes from enterprises for their investments or from household to buy a car or a home, is supposed to exercise a pressure on prices and so contributes to reaching the defined objectives. Unfortunately, this reasoning, which comes from the Sixties, is not anymore suitable to the economy operating mode. It was well applied to the lowly open economies but we are now in another time, the globalization one.
Inflation is not any more, in the developed economies, mainly caused by internal imbalances. It has been generated from 2022 by two external factors. The invasion of Ukraine by Russia has provoked a rapid rise of the fossil fuels prices and of some agricultural products. The international tensions which have resulted from the pandemic and from the degradation of the relationship between the United Staes and China have perturbated the supply chains of many industrial products, which has leaded, also, to prices increases.
In May, in most of the developed countries, inflation has started to decline. In France, with the harmonized figures, it has established itself at 6.1%, year on year, a figure near the eurozone average. In Germany, it was slightly higher (6.3%). In the U.S., it has significantly declined and, year on year, is near 4%. The United Kingdom is an exception with a price increase, still year on year, of 8.7%. These slowing are not going until the 2% level, which is the objective of the central banks. And it is not the result of their action because it mainly comes from the oil and gas prices fall obtained by the rebuilding of supply chains which don’t any more have their sources in Russia.
The States discarded themselves to the profit of the central banks of the fight against inflation, which protected them from the taking of unpopular measures as the freeze of the prices and so also of wages. But these ones do not any more have at their disposal the necessary tools to reach the objective they fixed to them. Even if these rate increases give the feeling of a voluntarist action, that is only an appearance because everywhere the real interests rates, calculated after the subtraction of the inflation rate, are still by large negative. In the eurozone, with a 6% inflation, and 3.5% rates, we reach a -2.5% real rate, which is largely inferior to the real rate observed before the successive crisis occurred from 2020.
That cautiousness, despite the declarations urging the monetary rigor, is imposed to them by the financial environment. In the past the interest rates fluctuations were essentially transferred to the foreign exchange markets. We remember the consequences of the Paul Volcker policy on the dollar exchange rate at the beginning of the Eighties. Today they have immediate impact on the financial markets and on the financial institutions whose de-stabilization could have much heavier consequences on all the economies than the surging of inflation. The sub-prime crisis and the Lehmann Brothers bankruptcy are still in all memories.
Time has so come to question the missions of the central banks in an environment which has completely changed and which makes obsolete the past reasonings on the relation between interest rates and inflation. After the 2007-2008 financial crisis they have constituted the Bale Committee which has imposed new prudential rules, Bale 3, to the banks and to the financial institutions to protect the economy against new crisis. In France that mission has been granted to the Prudential and Resolution Control Authority.
The level of the interest rates is, for the banking sector, an essential factor for its profits and its stability. The traditional model needs that the banks borrow with short-term issuances with rates inferior to these they will offer to their clients which will indebt themselves on mid and long-term periods. The margins they will get is a condition of their strength. To the opposite, when the rate curb is flat, due to the increases imposed by the central banks, or worst, when it is reversed, that action makes the whole banking system more fragile.
It is one of the reasons which makes that, despite an inflation level which remains very high, the central banks, in contradiction with their mandate, hesitate to rise the interest rates with too much brutality. It is so necessary to take the lessons from the current inflationist crisis to think to a redefinition of the sharing of responsibilities between the States and their Central Banks. We rarely reach in the same time two contradictory objectives, the coming back to a low inflation level, in conformity with the explicit or implicit mandates given in the past, and the protection of the stability of the banking and financing systems.
That reflection concerns in a first position the States. Measures adopted in the past at the European level had as an objective, through the introduction of the competition, to contribute to prices stability. The recent events, in the energy sector, have shown that the system put in place by Brussels has had the opposite effects. It is essential to draw from that the lessons and it is an illusion to think, for instance, that the increase of the interest rates will compensate the negative consequences on the prices of the liberalization of the energy markets.
The interest rates increase will so remain limited and as soon as the foreign environment will stop to exercise an inflationist pressure, the Central Banks will take that opportunity to stop their rates rises. They will congratulate themselves but we will not have to be fooled: they will be for nothing in the inflation reduction.