Weekly Winzer: Monetary and fiscal policy are out of step with the economic cycle

Why are central banks raising their policy rates? Because the current macroeconomic environment can best be described as inflationary growth. Economic activity remains robust, while inflation is above central banks’ targets. At the same time, the AI boom is adding to both demand and price pressures through high levels of investment in data centres, semiconductors, energy supply and infrastructure.

Despite this environment, real – i.e. inflation-adjusted – policy rates in several economies remained close to zero or even below zero for a long time. Monetary policy was therefore more supportive than restrictive. Fiscal policy, meanwhile, has so far shown few signs of credible consolidation of high budget deficits. However, simultaneously expansionary monetary and fiscal policies are difficult to reconcile with a period of robust growth and elevated inflation.

Bond markets have responded to this imbalance with rising yields. A benign interpretation is that they have anticipated the necessary policy rate increases. This is supported by the fact that not only nominal but also real yields have risen. If central banks were not to respond despite persistently high inflation, long-term yields could rise as well. In that case, however, a stronger increase in inflation expectations would be likely.

Pressure on central banks and finance ministries

Long-term government bond yields can essentially be broken down into two components: expectations for future short-term interest rates and a term premium that compensates investors for holding longer-dated bonds.

The recent rise in yields has been characterized by so-called bear flattening. Yields rose more sharply at the short end, causing the yield curve to flatten. This pattern suggests that rising expectations for future policy rates were an important driver of higher yields – and thus of bond market losses. This does not entirely rule out the influence of higher term and fiscal risk premia, but their role has so far been secondary.

Market pricing does not currently signal an acute crisis of confidence regarding the sustainability of government debt. Nevertheless, yields are approaching important thresholds. The longer new debt is issued and existing debt refinanced at higher interest rates, the more the average interest rate on the overall debt stock rises. This increases the pressure on finance ministries to present credible measures to reduce primary deficits. If such signals fail to materialise, term and fiscal risk premia could rise further.

Words alone are no longer enough

One major reason for this year’s rise in inflation is higher energy prices. Central banks can neither produce additional oil nor restore supply routes disrupted by geopolitical developments. Monetary tightening therefore does not address the immediate cause of an energy price shock.

It can, however, help prevent the initial price shock from becoming permanently embedded in wages, corporate pricing and inflation expectations. In several countries, there are signs that wage growth is slowing. This suggests that persistently high services inflation could gradually ease. Nevertheless, inflation in many economies has repeatedly remained above the 2% target since 2021.

Blaming new special factors each year for inflation’s failure to return sustainably to target is becoming increasingly less credible. In the Federal Reserve’s current projections, inflation does not return to 2% until 2029. Simply reaffirming a commitment to price stability is no longer enough under these conditions. Words need to be followed by action if monetary policy credibility is to be maintained.

Central banks are responding

The European Central Bank has already raised its deposit rate twice this year, by 25 basis points each time, from 2.0% to 2.5%. It justified its latest move by pointing to persistent inflationary pressures and expects average inflation in the euro area of 3.0% in 2026, 2.5% in 2027 and 2.1% in 2028.

On Wednesday, 16 September 2026, the Federal Reserve unanimously raised the target range for the federal funds rate by 25 basis points to 3.75–4.0%. The central bank pointed to solid economic activity, robust investment, a stable labour market and inflation that remains elevated.

The Bank of England left its policy rate unchanged at 3.75% on 17 September 2026. Three members already voted in favour of an increase to 4%. The Bank stressed that only limited second-round effects from the energy price shock had been observed so far, but that the risks to inflation would increase the longer the period of high energy prices persists.

The Bank of Japan announced on 18 September 2026 the increase from 1.0% to 1.25%.

By July 2027, markets are pricing in further rate increases of around 85 basis points (= 0.85 percentage points) for the European Central Bank, 76 basis points for the Federal Reserve, and around 94 basis points each for the Bank of England and the Bank of Japan. It is therefore fair to speak of a broad-based cycle of interest rate increases.

The Fed sends a clear signal

The Federal Reserve’s rate increase attracted particular attention. It is responsible for price stability and maximum employment in the world’s largest economy and most important financial market. At the same time, tensions have developed between the US administration and the central bank. Following the decision, the US President once again called for significant and rapid interest rate cuts.

Last year, the Fed cut its policy rate in three steps from 4.5% to 3.75%. These moves were described as insurance against increasing downside risks to the economy and labour market. However, the feared risks have so far not materialised to the extent anticipated.

Fed Chair Kevin Warsh explained the latest change in direction with a simple diagnosis: inflation was too high and had been so for too long. At the same time, the US economy appeared to be strengthening. Hiring, private-sector income, business investment and lending had improved. The Fed had therefore withdrawn some of its monetary policy support.

Although the rate increase had been expected, the initial market reaction was consistent with a hawkish surprise. Equity prices temporarily fell, while US Treasury yields and expectations for the future path of policy rates rose. At the same time, market-implied inflation expectations declined, while real yields increased. This pattern is consistent with credible monetary tightening: higher expected real interest rates, but lower long-term inflation expectations.

Higher for longer

The Fed’s new projections also support this interpretation. Compared with June, the estimate for economic growth in 2026 was raised to 2.3%. The inflation forecast increased to 3.7%, while the expected unemployment rate was lowered to 4.1%.

The estimate of the longer-run policy rate, which is often interpreted as an approximation of the nominal equilibrium interest rate, was raised again. A higher equilibrium rate would imply that, at an unchanged policy rate, monetary policy is more expansionary – or less restrictive – than previously assumed.

The decision was unanimous. The new projections also signal at least one further rate increase in 2026, while the median projection for the end of 2027 indicates an unchanged policy rate. The central message is therefore not simply “higher”, but “higher for longer”.

Conclusion

The policy rate increases are correcting an important macroeconomic imbalance. Robust growth, expansionary fiscal policy and persistently high inflation point to the need for higher real interest rates. If monetary policy remains too loose in such an environment, the risk of overheating in both the real economy and financial markets increases.

In the short term, higher policy rates can weigh on equity and bond valuations. Over the longer term, however, preserving monetary policy credibility is more important. A credible central bank anchors inflation expectations, protects purchasing power and reduces the risk of even more aggressive rate increases at a later stage.

“Higher for longer” is therefore not only a burden for financial markets. It is also a necessary signal of stability.

 

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