Scenarios

Most likely: Gradual easing

The most likely option involves central banks cautiously lowering interest rates to sustain economic growth, and keeping them low unless inflation resurges. The target could be set at around 3 percent for the U.S. federal fund’s rate and 2 percent for the European Central Bank deposit facility rate. Such a move would meet with the approval of the political and business spheres, and there would likely be economists ready to provide theoretical justifications for this course of action. After all, this trick worked from the late 1990s until 2021, and some may think it could work again. Central banks, aware of the short timeframes that characterize political cycles, would bear a minimal cost if the gamble backfired and the threshold were reached earlier than expected. 

Less likely: Defining boundaries 

A second, less likely option would be for policymakers to seek to determine where the threshold lies for maintaining tolerable inflation and acceptable interest rates. On this path, policymakers would note that American households and voters are seriously concerned about capital incomes (private pension plans play a larger role in the U.S. than in Europe) and private debt, which amounts to some $140,000 per household. In comparison, average household debt is about $42,000 in Italy, $56,000 in Germany and $70,000 in France. 

During the 2010-2020 period, nominal interest rates on personal loans in the U.S. were close to 10 percent, and Americans have historically reacted nervously as soon as rates started rising above that level (they are currently 12 percent). They also focus on nominal rates, as incomes tend to lag behind inflation. On the other hand, capital-income earners expect their quasi risk-free assets to yield at least 1 or 2 percentage points in real terms. Failure to meet this target encourages them to take chances and move their wealth to the stock market. This puts pressure on the bond market and causes interest rates to inch higher.

The authorities are faced with a dilemma: To defuse alarm, they must ensure that nominal interest rates drop a couple of points. At the same time, they have to keep inflation below 3 percent, so that the real return on safe securities is consistent with people’s expectations. To achieve this, central banks must bring money printing almost to a halt in the hope of killing inflation expectations, drive interest rates down to encourage the banking sector to expand their lending activity (making the money supply rise), but also be ready to slam on the brakes should price inflation rise above 3 percent. This is a tricky path; the record of experimenting with fine tuning is poor, and economic growth is required to ensure that a modest rise in the money supply does not translate into excessive price inflation. But it could work.

The above applies to the U.S., but the line of reasoning is similar for Europe. However, the European Central Bank may have an easier job: European households are, as noted, less indebted than their American counterparts, and therefore less sensitive to interest rates. Moreover, price inflation is currently lower than in the U.S. and more or less under control. All in all, European authorities face laxer threshold constraints, and holding a steady course would not be overly problematic. Europe’s major problem is the EU’s relentless ambition to engage in grand and very expensive, presumably bond-financed projects, accompanied by growth-killing regulatory straitjackets. That is a recipe for failure. 

Somewhat less likely: Abandoning prudence

The third and somewhat less likely scenario entails a situation in which central bankers on both sides of the Atlantic are put under pressure to depart from a prudent policy path and engage in money printing and/or aggressively cut interest rates to solve public finance problems. While this approach may offer a temporary respite, it risks plunging Western economies into a monetary crisis, with geopolitical ramifications potentially favoring China and most low-income, highly indebted countries.

China, for one, would eagerly exploit any dollar and euro crises and renew its efforts to make the yuan a widely accepted reserve currency. Meanwhile, the low-income, highly indebted countries, being burdened by heavy debt servicing costs – high interest rates on loans outstanding and repayment of principal – see two possible outcomes: the fall of the dollar and the euro, or default on their foreign debts. Nonetheless, these geopolitical consequences would probably pale in comparison with the domestic dramas that a monetary meltdown would trigger in Western countries. 

The most probable scenario will not center around the official 2 percent inflation target. Instead, policymakers are likely to shift their focus toward the constraints imposed by acceptable nominal interest rates and price inflation. Although there is some flexibility in these in the short term, it is clear that in the long run interest rates cannot be significantly lowered from current levels without risking rampant money supply growth. A crucial factor will be the ability of central bankers to disregard persistent calls for continued public spending and increased debt – both domestically in the U.S. and Europe, and further afield, from low-income countries.