“The era of low rates may not be over yet”

“The era of low rates may not be over yet”
“The era of low rates may not be over yet”

European and American central banks appear to be taming inflation without triggering a recession. That’s no small feat, but the hardest part may be yet to come. High public debt, an aging population, rising protectionism, and geopolitical instability promise to make life difficult for central bankers.

The road ahead still promises to be bumpy, but the final destination is in sight. The European Central Bank (ECB) expects the euro area to return to price stability by the end of 2025, with inflation around 2%. “We have to be honest. Central banks have done their best to keep inflation under control, but the decline in inflation is mainly due to lower energy prices,” said Bruno De Backer, head of the National Bank’s Monetary Policy Group, at the 11e edition of the Trends Summer University (TSU) in Knokke.

It is remarkable that the initially hesitant and then very aggressive reaction of central banks to the inflationary surge of 2022 did not cause a recession.

“Many have wondered why the economy has not abandoned rate hikes more easily,” continues Bruno De Backer. “But look at the level of real interest rates. The ECB quickly raised the policy rate to 4%, but with inflation at 10%, this produced an extremely negative real interest rate of minus 6%. Real interest rates are currently slightly above zero. This suggests that monetary policy is now restrictive, but this has only been the case for a short time and it is probably not very restrictive.”

Soft landing

The Western economy has also stayed afloat because it refueled during the pandemic, says Ronald Temple, Chief Market Strategist at Lazard Asset Management. “US households have accumulated a $2.5 trillion savings surplus during the pandemic,” adds Roland Temple. “This has allowed consumers to spend to avoid a potential recession. The US economy has been at full employment for the past two and a half years. The unemployment rate has been below 4% for 30 months. Today, these savings surpluses are largely depleted, but the US economy can sustain 2% growth in 2024 and 2025. This is a remarkable achievement, given the most severe monetary tightening in 40 years. The US central bank (the Fed) has managed to keep the economy on a gentle footing. One could even call it a ‘non-landing’ rather than a soft landing.”

Governments have spared no expense during the pandemic to keep the economy afloat. “What’s really different about this cycle,” says Ronald Temple, “is the expansionary fiscal policy of the United States. According to IMF calculations, during the pandemic, global fiscal stimulus reached $10.8 trillion. The United States accounted for half of that. So 4 percent of the world’s population received 50 percent of the fiscal stimulus. Strong domestic demand played a significant role in the rise in inflation in the United States, in addition to supply chain bottlenecks and disruptions in labor markets.”

It is important to note that inflation expectations have remained anchored at around 2%, adds Bruno De Backer: “This is a big difference compared to the inflation waves of the 1970s. In the late 1970s, inflation expectations in the United States reached 10%. If everyone expects inflation of 10%, it is extremely difficult to bring it down to 2%. In the early 1980s, Paul Volcker had to restore the Fed’s credibility by pursuing a particularly restrictive monetary policy. This time, the Fed did not have to harm the economy as much, precisely because inflation expectations remained anchored.”

Since peaking at around 10%, inflation has fallen significantly in both the US and Europe. However, the final stretch promises to be the most difficult, as a slight wage-price spiral has set in in the labour-intensive service sectors.

“Real wages have fallen in the US over the past two years. Workers want compensation for this loss of purchasing power,” adds Roland Temple. “If the labor market remains tight, wages will continue to rise quite rapidly, forcing companies to raise prices. The US central bank will therefore remain cautious. In the meantime, tensions in the labor market are easing somewhat, opening the way for more moderate wage growth. The Fed may start cutting rates in September. We expect three rate cuts in the US this year. In the eurozone, we also expect two interest rate cuts this year.”

Protectionism imminent

If inflation seems to be under control in the short term, there is no shortage of pitfalls that could revive it.

As early as this fall, the possible re-election of Donald Trump to the presidency of the United States and a new surge in protectionism are looming. Is globalization living its last hours?

“For the moment, there is no deglobalization,” says Ronald Temple. “Expressed as a percentage of global GDP, international trade is no longer increasing, but it is not decreasing either. Imports come more from allied countries or at least from neutral countries. This creates limited additional inflationary pressure. The American presidential election will be very important in this context. Donald Trump has promised 10% tariffs on everything, including imports from friendly countries. For imports from China, Trump is even talking about 60% tariffs. The United States imports $550 billion worth of goods from China each year. So that’s potentially $330 billion in tariffs. These are considerable sums, even for a US economy with a GDP of $28 trillion. It will be very difficult for companies to pass on 60% tariffs to consumers. And what will happen if China and Europe take protectionist countermeasures?”

End of peace dividends

A re-election of Donald Trump could also have major geopolitical consequences, which would also be inflationary.

The peace dividend was a mirage. We have dismantled our ability to defend ourselves.” – Ronald Temple (Lazard AM)

“We have had peace in Europe for the last 75 years because the concept of deterrence works,” Ronald Temple continues. “The adversary knew that NATO was united and ready to fight an aggressor. With Trump as president, the resolve of the United States is called into question. This is particularly risky for the security of Europe, which, inevitably, whether Donald Trump or Joe Biden is elected, must invest much more in defense. Last year, Russia produced 1,400 tanks and Europe 100 tanks. Even if Europe wanted to, it could only produce 500 tanks at most over the next two years. Europe must build an industrial complex capable of manufacturing military equipment. The world must accept that the peace dividend was a mirage. We have dismantled our capabilities to defend ourselves.”

Pressure on central banks?

The extra defense spending comes at a time when many Western governments are cash-strapped and struggling with rising interest rates. The climate transition will also require billions of investments over the coming years. How much pressure will governments put on independent central banks to bail them out financially through accommodative monetary policy?

“European tax rules give credibility to the independence of the ECB.” – Bruno De Backer (BNB)

“As a central banker, it is my duty to remind that governments are responsible for the health of their public finances,” says Bruno De Backer. “Monetary management is entrusted to an independent central bank to prevent governments from printing money to finance their policies. Public finances must remain healthy to prevent politicians from putting pressure on central banks. European fiscal rules give credibility to the independence of the ECB. Should central banks allow too lax a fiscal policy? Absolutely not. This means that key interest rates will remain high if central banks deem it necessary to fight inflation. Governments will then have to face higher interest charges.”

The impact of demographics and AI

However, central banks do not only have to deal with inflationary forces. European demographics remain a source of deflation that should not be underestimated. The era of inflation and low interest rates, which was the norm in Europe in the years before the pandemic, may not be over.

Artificial intelligence can do for the service sector what globalization has done for the goods sector.” – Ronald Temple (Lazard AM)

“Life expectancy is increasing, but the retirement age remains stable. This means that people have to save more. And if people save more, this puts downward pressure on rates. We could return to a world of structurally low interest rates,” says Bruno De Backer.

Finally, to what extent can the breakthrough of artificial intelligence precipitate inflation?

“I compare the rise of AI to globalization,” says Ronald Temple. “Globalization has put downward pressure on inflation for decades. China’s integration into the global economy added 500 million workers to the global labor supply, which reduced the bargaining power of Western workers. That was bad for society, but we paid less for goods. China exported deflation. AI can do for the service sector what globalization did for the goods sector. AI can generate large productivity gains in services, which can lead to lower prices if some of those gains are passed on to consumers.

Find all the articles and photos from our Trends Summer University 2024

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