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Six reasons why central banks cannot raise interest rates sharply


16 March 2022

Many investors are afraid that monetary policies will become highly restrictive in order to fight inflation, and that this will lead to a sharp decline in equity markets. But there are many reasons why central banks are likely to be more cautious today than in the past, leading to much smaller rate hikes, analysts at Natixis report.

Central banks are likely to be cautious

The much higher level of public debt ratios than in the past means that a rise in interest rates would worsen public finances markedly more than in the past. “The much higher level of wealth than in the past means that a fall in asset prices caused by the rise in interest rates would trigger a greater negative wealth effect than in the past, driving down domestic demand.

Central banks now have numerous objectives linked to real activity: obtaining a high employment rate to reduce inequality, obtaining high potential growth to reduce debt ratios. A restrictive monetary policy is clearly at odds with these new objectives.

Recent developments show that wage indexation to prices remains low. This means that inflationary surges push down real wages and therefore weakens domestic demand, which exempts central banks from having to do so.

Central banks are determined to support the energy transition. This requires very large investments (4%s of GDP per year for 30 years), some of which have very low financial returns (they generate climate externalities). For these investments to be made, long-term interest rates must therefore remain low.

If inflation comes from negative supply shocks, it is completely counterproductive to raise interest rates, as this hike in interest rates discourages investments that could loosen this supply constraint.

The most likely is then a moderate hike in central bank interest rates, with a terminal (stabilised) interest rate of around 2.5% in the US and 1% in the eurozone. This visible but moderate hike in central bank interest rates is unlikely to be a threat to equity markets.”

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