Raising rates to fight inflation may backfire: the case of floating-rate loans

Is a monetary policy tightening always an effective weapon to fight inflation? It depends on firms’ debt structures. This is the conclusion of the policy brief “The supply side of monetary policy: How Floating-Rate Loans Blunt the ECB’s Fight Against Inflation”. The policy brief was written for Suerf – The European Money and Finance Forum by Fabrizio Core (Luiss Guido Carli), Filippo De Marco (Bocconi University and Baffi Centre), Tim Suerf (Nova School of Business and Economics), Glenn Schepens (European Central Bank).

The policy brief investigates whether the effectiveness of monetary policy is hindered by the presence of floating-rate corporate loans. After a rate hike, firms with floating-rate loans keep prices elevated to offset higher borrowing cost, a supply-side effect offsetting the standard demand-side transmission. Using monthly data on product-level prices, industry-level inflation rates and the confidential European Central Bank euro-area credit register from 2021 to 2023, the authors of the policy brief find that the short-run impact of monetary tightening on inflation is 50% smaller when firms rely on floating-rate loans.  

It implies that the fight against inflation depends not just on how much central banks raise rates, but on how those rate changes affect firms’ behaviour. In a world where many euro-area firms borrow at floating rates, the monetary transmission mechanism includes a cost-based supply-side channel: higher interest rates lead to higher prices at some firms, not lower ones. This does not mean monetary policy is ineffective. But it does mean that policymakers must account for the financial structure of the economy and the distribution of pricing power among firms. Understanding these frictions will be critical to designing effective responses to future inflationary pressures.

In particular, monetary policy makers should consider the structure of floating-rate corporate debt when assessing the likely effects of rate hikes on inflation. This is especially important in the euro area, where cross-country variation in floating-rate corporate loans is substantial.

Moreover, the results highlight that when the policy rate increases borrowing costs for firms with floating-rate debt, it can look, at least temporarily, like inflation is not responding. Understanding this delay can prevent premature policy reversals or misinterpretation of inflation persistence.

Finally, the results of the policy brief point to a potential role for prudential or competition policy. Encouraging fixed rate borrowing for corporate borrowers through financial regulation, or improving competition in product markets, could enhance monetary transmission and reduce inflation inertia.