Weekly Update - Why long-term rates are rising (and why it could last)

The European Central Bank’s latest rate hike may appear counterintuitive. Today's inflation is largely driven by higher energy prices resulting from geopolitical tensions and supply constraints. Raising interest rates will neither increase the production of oil and gas nor directly lower their prices. Instead, the ECB aims to prevent this shock from spreading to wages, services prices and inflation expectations. From that perspective, the decision can be justified at the euro area level, even though the ongoing rise in long-term interest rates calls for caution. It may also appear difficult to reconcile with the specific circumstances of the French economy.

The ECB cannot prevent the energy shock itself, but it must ensure that it does not become permanently embedded in the broader economy. In August, euro area inflation reached 3.3%, well above the 2% target, largely reflecting a 14.3% increase in energy prices. A temporary overshoot of the target does not automatically warrant tighter monetary policy, as the ECB operates with a medium-term horizon. However, the longer the energy shock persists, the greater the risk that it feeds into corporate pricing, wage negotiations and households' inflation expectations. By raising rates, the ECB is therefore not attempting to address the initial source of inflation. Rather, it seeks to moderate demand and prevent second-round effects that could transform a sector-specific price increase into more generalized inflation.

That said, the rate hike reflects more of an insurance strategy than a need to cool an overheating economy. So far, evidence of broader inflationary spillovers remains limited. Euro area core inflation, excluding energy and food, eased from 2.5% to 2.4% in August and therefore remains relatively close to the ECB’s target. The European economy has proved more resilient than expected, but there are few signs of overheating at this stage. At the same time, the broad-based increase in long-term interest rates is already tightening financial conditions. This reflects the resilience of global growth, more persistent inflation risks and rising public and private financing needs. Higher borrowing costs are likely to weigh progressively on investment, real estate activity and consumption. In other words, part of the monetary tightening is already occurring through market channels, arguing for a gradual approach rather than an abrupt tightening cycle.

A decision that is coherent for the euro area as a whole may nevertheless appear overly restrictive from a French perspective. With headline inflation at 2.7% and core inflation limited to 1.2%, France remains among the countries experiencing the weakest inflationary pressures. Economic activity is also markedly softer than elsewhere in the euro area: growth is close to zero, wage growth is more moderate and credit expansion remains subdued. Domestic price pressures therefore appear less intense than in the rest of the monetary union. However, the ECB does not set policy according to French economic conditions alone. It conducts monetary policy for the euro area as a whole. A limited and gradual rate increase can therefore be appropriate on average, even if it places an additional burden on the least dynamic economies. The challenge is to preserve the credibility of the 2% inflation target without unnecessarily deepening the economic slowdown.

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