La Française: ECB monetary tightening, when will the effects be felt?

19 juni 2023

The time it takes for monetary policies to have an impact on the economy has been the subject of numerous research papers over the last few decades, and the conclusions often vary significantly. The academic conclusions can be summarised as follows:

• Restrictive monetary policies take longer to materialise than expansionary policies.
• The effects are not linear, which means that short-term effects may differ from the longer-term effects. For example, an initial rise in interest rates may lead to a stronger immediate reaction in certain interest-sensitive sectors, such as real estate or consumer loans, before the effects gradually spread to the economy as a whole.
• The time lag can vary from three to six months to even three years, depending on financial stability and the efficiency of monetary transmission channels.

Given the characteristics of the current cycle, it seems fairly logical to assume that the lag will be extensive, maybe up to three years. We are coming out of ten years of highly accommodative monetary policy, which have enabled the vast majority of private-sector actors to enter this new phase with healthy balance sheets and very low financing costs.

As a result, the rate hikes have had a fairly limited impact on these actors. We should also bear in mind that while monetary policies have become restrictive, this is not at all the case for fiscal policies, which have been and remain very generous: the more governments protect their economies by limiting the negative effects of inflation, the harder it is to defeat inflation, forcing central banks to adopt increasingly restrictive monetary policy.

Taking all these factors into account, it is logical for the ECB to think that the effects of its monetary tightening will be more palpable in 2024 than in 2023.

If we take into account the current strength of the labour market, the shortage of available labour and the eagerness of employees to regain all or part of the purchasing power lost over the last two years, it is likely that wage inflation will continue over the coming months or quarters.

Moreover, if fiscal policies continue to offer support to households and in turn consumption, which accounts for just over half of eurozone growth (51.6%; Source: Eurostat), we may even see wage inflation continuing for longer. Assuming wage inflation remains at around 4 to 5%, i.e. the current rate, it will be extremely difficult to see core inflation fall significantly in the eurozone.

Markets are anticipating that inflation will be around 3% at the end of the year and higher core inflation of around 4% (Source: Bloomberg). It is interesting to note that the dispersion around core inflation forecasts is currently fairly high, which is not illogical given macroeconomic uncertainty.

If we assume that wage inflation persists, it will be difficult to bring the rate of inflation down significantly in the eurozone, which will lead to rising inflation expectations. At present, the market is working on the assumption that the ECB will cut interest rates by around 80 basis points in 2024. However, in a climate of persistent inflation, these rate cuts would no longer serve any real purpose.

Ultimately, everything will also depend on the resilience of the European economy, whose growth is currently close to zero at best, and on the dynamics of credit supply and demand. A credit event could undermine financial stability – which the ECB holds dear– thus sharply increasing the speed of monetary transmission, but we are not there yet.