- Not so long ago, money market interest rates were negative in Europe, and the French government could borrow almost for free, even for long maturities...
- Inflation seemed to have disappeared from the radar, to the point where central banks were mainly concerned about sluggish prices, struggling to predict when they would end.
- It took a global health crisis and a war on Europe's doorstep for things to change, perhaps permanently.
- To counter the depressive effects of Covid-19, central banks have massively repurchased government debt, which has itself ballooned. These very loose liquidity conditions have supported demand during a period of supply shortages and reignited inflation, beyond all expectations.
- We know what happened next. Monetary conditions went from expansive to restrictive; imbalances in the goods market were corrected; and price increases slowed.
- Many observers nevertheless believe that we have entered a period of persistently higher inflation than before the pandemic. There are several of arguments for this: the cost of the green transition (also known as “greenflation”), an aging population creating labor shortages and upward pressure on wages, etc.
- Does this mean that the 2% target is no longer relevant? We do not think so.
- As already mentioned, the underlying trend in prices was low before the pandemic: just over 1% excluding volatile items in the Euro area. A move to 2%, i.e. a doubling of the rate, would indeed constitute a regime change, but would ultimately only bring inflation back to its target.
- As for the possibility of a stronger drift, this is unlikely, as inflation is also (and for some, exclusively) a monetary phenomenon. However, we do not see any signs of a break in this area. After soaring during the COVID period, the ratio of M3 money supply to GDP has returned to a gentle slope, very similar to that seen before the pandemic.
- Market expectations, as reflected in “inflation break-even rates,” remain anchored around 2%.
- In summary, while the 2% inflation target is not new and remains credible, there is a chance that it will materialize more often in an environment where geopolitical instability has become the norm.
- This should lead the ECB to be more vigilant. Barring any major accidents, a return of monetary rates to around zero, or even less below zero, seems unlikely.
- Long-term yields, which partly reflect expected short-term rates, should therefore remain higher for some time. The term premium demanded by investors is also likely to increase, at a time calls from the official sector to the debt market are becoming massive.
- At what level could average long-term rates in the eurozone ultimately stabilize? The economy's potential growth rate is often used as a point of convergence towards equilibrium. The OECD estimates this at 1.2% per year in real terms, or around 3% per year in nominal terms, assuming an inflation target of 2%.
- It so happens that 3% is the actual interest rate around which the eurozone countries are currently borrowing (for ten years).
- We are therefore a long way from the very low, but partly abnormal, levels that prevailed before the pandemic, which is good news for savers but not for governments, whose budgetary equation is complicated by the increased interest burden on debt.
