What matters more: curbing inflation or slowing economic growth?

In September this year, the U.S. Federal Reserve and the European Central Bank (ECB) raised their key interest rates to 4.0% and 2.5%, respectively. The key interest rate is the minimum rate at which a central bank lends money to commercial banks and accepts deposits from them. While the ECB raised its rate for the second time since the armed conflict in the Middle East began, in the United States it was the first increase since July 2023.

Why does a central bank raise its key interest rate? The main goal is to slow price increases and curb inflation. After the September rate hikes in the United States and Europe, participants in global financial markets did not rule out another increase in October this year, as inflation continued to exceed the target level. However, this is unlikely to happen because unemployment is rising and job creation is slowing in the United States, while financial market instability in France has intensified amid a rapid increase in public debt and a widening budget deficit.

Although the main cause of rising inflation—the impact of geopolitical tensions on energy prices—has yet to be eliminated, the monetary authorities in the United States and the European Union have nevertheless decided to wait and see, since raising the key interest rate also has a downside. It generally makes borrowing more expensive, cools consumer activity, and slows economic growth. In addition, a stronger national currency makes a country less competitive in global markets.

The rate hikes in the United States and Europe were a response to the ongoing armed conflict in the Middle East, the introduction of trade tariffs, and a rapid increase in investment in artificial intelligence. Despite persistently high inflation, investors consider a near-term rate hike extremely unlikely. At the same time, persistent inflation in the U.S. services sector and the Fed’s determination to combat rising prices mean that a rate increase remains possible. However, such a move is not expected before December this year.

Strong inflationary pressures also persist in Europe, where economic growth is expected to slow. France is currently the weakest link: acute financial and economic problems there are compounded by growing domestic political instability. This suggests that monetary policy tightening will continue, making another ECB rate hike after a brief pause quite likely.

Author: Doctor of Economics, Professor at the Department of World Economy and International Finance, Financial University under the Government of the Russian Federation, Igor Alekseyevich Balyuk.