The price of the new economic equilibrium

It is true that economic activity continues to show surprising resilience in the face of accumulating supply-side disruptions. However, the tightening of financial conditions, caused by the significant upward shift in the interest rate curve, poses a new challenge for the coming quarters.

In this context, central banks will once again take centre stage in economic policy – nothing new under the sun – as they are forced to move interest rates into more restrictive territory to rebalance supply and demand and minimise the risk of second-round effects. And this is with the awareness that there is little they can do about the direct impact on inflation of rising oil prices caused by supply restrictions: neither the Fed nor the ECB can produce an additional barrel of crude by raising interest rates. The real difficulties begin when the energy disruption threatens to spread to other prices, alter expectations, and affect wages, corporate margins and pricing mechanisms. The challenge, therefore, will be how monetary conditions can be tightened in a controlled manner so as to protect the inflation target without unnecessarily penalising economic activity or jeopardising financial stability.

Right now, although it is still too early to have a clear picture, the cost to growth of the current interest rate hikes ought to be compatible with a slowdown in activity without triggering a recession. This outlook is supported by the fact that much AI-related investment is less sensitive to financing costs, as well as the strength of labour markets and private sector balance sheets. However, this resilience conceals a paradox: if the economy is less responsive to monetary tightening because the traditional transmission channels have weakened, central banks may be forced to keep interest rates higher for longer in order to achieve the same effect on demand. This could be a particularly narrow path if, as now seems likely, equilibrium interest rates are significantly above the levels of the previous decade.

And there are reasons to think this may be the case. The enormous investment needs related to AI, defence, the energy transition and infrastructure are increasing the demand for capital. If savings do not increase at the same rate, the result should be a higher equilibrium real interest rate. Thus, what we still view as an anomaly, influenced by an exceptional decade of near-zero or even negative rates, could actually be the emergence of a new normal. In the short term, the investment race in data centres, semiconductors, power generation and networks is simultaneously increasing the demand for capital and energy, which is pushing real interest rates upwards and complicating the disinflation process. In the medium term, however, if these investments ultimately yield the expected productivity gains, AI would expand the economy’s supply capacity and have disinflationary effects. The investment is happening today; the productivity will come tomorrow. The big question is how long it will take to arrive and with what intensity.

Time is thus an essential factor, both for the positive effects of AI to materialise and for absorbing the new supply disruption. And this is precisely where one of the main risks of the current scenario lies: investors may start to doubt the possibility of an «immaculate disinflation», meaning a return of inflation to central banks’ targets with minimal costs in terms of growth and employment. In that case, the seemingly calm coexistence between rising bond yields and stock markets near their peaks would also be tested.

Ultimately, the debate should perhaps not focus solely on identifying the interest rate threshold beyond which financial instability may increase, but rather on determining what level of rates is compatible with the new balance between savings and investment, inflation and growth. Higher interest rates do not necessarily represent only the cost of correcting past fiscal and monetary imbalances. They may also be, at least in part, the price to pay for financing future transformations – a future where vast amounts of capital will need to be mobilised in a world of greater trade, geopolitical and financial fragmentation. Establishing the price of this new economic equilibrium will be one of the main tasks for the markets in the coming months. As with any regime change, not everyone will be equally prepared to pay for it.