Towards the end of 2021, the disrupted supply chains caused by COVID-19 combined with a decade of loose monetary policy to kick-start inflation around the developed world.

Central banks, initially slow to respond, went on to tighten policy, and official interest rates have risen sharply. Retail lending rates inevitably followed and governments face political pressure to ease the pain for borrowers, including businesses and mortgage-holders.

A few central banks have skipped the recent round of increases amidst evidence that the medicine is working: inflation rates appear to have peaked and there are predictions that further increases from the central banks will be modest.

Last week’s Eurostat figures showed another moderation in consumer prices, still growing 4.3% on a year-to-year basis, but getting down towards the official target rate of 2%. That target could now be reached late in 2024, or in 2025, and borrowers will be hoping for a return to rock-bottom charges for bank credit.

Even if inflation slackens off quickly, they are likely to be disappointed.

Borrowers would like to know whether the run of central bank rate increases will continue, since these drive commercial bank charges for loans, and whether there will be a ‘new normal’ anything like the low-interest, easy-money period.

It is most unlikely: there may never be a return to official central bank rates at zero (negative in some cases), in which case the abnormal period of cheap money is over.

Governments were able, for several years, to borrow at negative rates, in effect to charge investors for the privilege of holding government bonds.

This had rarely happened before in the long history of sovereign debt markets and arose in unique circumstances, including the money-creation where central banks finance governments directly.

New normal

High household savings, largely involuntary due to the COVID-19 lockdowns, concealed the inflationary pressures, but the speedy recovery put paid to the reprieve.

There will, barring some unforeseen geopolitical or pandemic emergency, be a ‘new normal’ rather like the monetary policy and interest rate world that was the ‘old normal’, before the financial crisis of 2008 to 2012 which almost upended the Eurozone common currency area.

In that world, inflation around 2% – still the official target in almost all developed countries – implied wholesale money market rates a little higher, government borrowing rates a shade higher again, and mortgage lending rates in the 4% or 5% area. For loans without collateral, add another few points.

If inflation settles down to a new normal of 2%, the explicit target of the European Central Bank (ECB), the pattern of interest rates will find a consistent relationship with inflation that is sustainable. That means official interest rates, including the rate at which the ECB lends wholesale money to the commercial banks, would be a little higher than 2%.

The current Irish flirtation with mortgage interest subsidies, popular even with left-wing political parties is unsustainable

The current rate, however, is at 4% and may be held at that level or go another quarter-point higher at the next ECB rate-setting meeting scheduled for Athens on 20 October.

Measured inflation in the Eurozone may have peaked and any overshoot in tightening monetary policy would hurt economic growth rates, which already look to be faltering. Whenever the rate hikes are paused, the key question is the pace of subsequent reduction and the ultimate destination.

On past experience, the reductions will be gradual and the rate will eventually settle down somewhere just above the 2% inflation target once its attainment seems to be assured. That could be in late 2024 or early 2025 on current market expectations.

Endgame for ECB

The ECB was never comfortable with interest rates below its target rate of inflation. Negative real rates of interest were introduced after the 2012 crisis and sustained reluctantly to support the pandemic response.

Should the monetary tightening do its job and cool inflation, as appears to be happening, the endgame for the ECB will be official interest rates back in the zone of 2% to 2.5%, which would offer only limited relief for governments whose borrowing costs have risen well above that level in some cases.

For business borrowers, it is unrealistic to expect that cheap money is set to return as soon as the central banks declare victory over the inflation surge. Part of the recent increase in interest rates will prove to be permanent.

‘Expensive money’

Governments which sought to offset the rising cost of debt for business and households through explicit subsidies, for example through warehousing tax debts at zero interest, have now started to unwind these emergency measures.

Failure to do this, aside from the cost to the budget, would conflict with the monetary policy stance, which is to cool the economy with more expensive money.

The current Irish flirtation with mortgage interest subsidies, popular even with left-wing political parties – despite their regressive impact – is unsustainable for the same reason.

Borrowers should get used to more expensive credit.