Inflation and growth

While inflation has been caused primarily by the pandemic-led recession that fed into supply cuts, and the return of which was naturally stickier than the rise in demand as vaccine rollout increased, yet is also due to the element of ‘greed’ that corporations reportedly exhibited in the artificially created slow pace of supply pickup to push prices up, and in turn profits.

This means that in addition to increasing policy rate globally to curb inflation from the channel of aggregate demand, there is also a need to reduce prices in both developed and developing countries by checking these artificially created profit margins by the business sector through greater government intervention in markets.

This is indeed important to check inflation and keep the world on track of economic recovery. Given these circumstances, the usual policy of overly-emphasized aggregate demand management will not be able to reduce inflation appropriately, and at the same time will have a decelerating effect on growth.

Policymakers at the IMF (International Monetary Fund) and those in developed and developing countries who have traditionally overly reliant on pro-cyclical policy approach will need to balance their stance accordingly, whereby greater price controls will need to be introduced to check the element of greed in prices, and increase policy rate in a less hawkish way at the back of internalizing properly the supply-sided channel of inflation and the active role of unwarranted profit margins reportedly existing there.

Already, rising inflation, among other factors, is expected to put a strong damper on economic recovery globally. The World Bank, for example, has downgraded economic recovery prospects for this and next year, whereby it indicated: ‘Following a strong rebound in 2021, the global economy is entering a pronounced slowdown amid fresh threats from Covid-19 variants and a rise in inflation, debt, and income inequality that could endanger the recovery in emerging and developing economies, according to the World Bank’s latest Global Economic Prospects report. Global growth is expected to decelerate markedly from 5.5 percent in 2021 to 4.1 percent in 2022 and 3.2 percent in 2023 as pent-up demand dissipates and as fiscal and monetary support is unwound across the world.’

A correct policy approach is needed, which would mean that not only is reliance on monetary policy tools critical, governance/fiscal policy interventions are also quite important. This is not just important for economic recovery in developed countries, but also for developing countries where policy rate hike in rich, advanced countries would mean rising cost of borrowing for developing countries with obvious difficult consequences of balance of payments management, and debt sustainability.

A recent IMF blog ‘Emerging economies must prepare for Fed policy tightening’ pointed out in this regard: ‘…spillovers to emerging markets could also be less benign. Broad-based US wage inflation or sustained supply bottlenecks could boost prices more than anticipated and fuel expectations for more rapid inflation. Faster Fed rate increases in response could rattle financial markets and tighten financial conditions globally.

These developments could come with a slowing of US demand and trade and may lead to capital outflows and currency depreciation in emerging markets. The impact of Fed tightening in a scenario like that could be more severe for vulnerable countries. In recent months, emerging markets with high public and private debt, foreign exchange exposures, and lower current-account balances saw already larger movements of their currencies relative to the US dollar.’

Hence, it is important to have more cautious policy rate increases and introduction of greater price controls to have a meaningful impact on efforts aimed at curtailing inflation and allow greater global economic recovery at the back of greater and more inclusive investment. Rather than going hawkish on policy rate increases, given an almost four-decade high inflation rate in US at 7 per cent (Fed has reportedly considered even more than three upward revisions in policy rate) and rising energy prices putting pressure on inflation in Europe, a more balanced and greater-suited balanced policy approach is indeed needed.

A Cato Institute blog ‘Inflation: a brief look back, and a path forward’ by Norbert Michel highlighted the need for exercising caution with regard to tightening of monetary policy stance. It also underscored the need for focusing appropriately with regard to dealing with the supply-sided channel of inflation. According to Michel, for example: ‘In contrast, I have been urging caution, warning against the damaging effects of a prematurely tight monetary policy.

The reason for this view rests on the underlying cause of the recent episode of inflation: unprecedented economic disruptions caused by the Covid-19 pandemic and the government’s responses. The pandemic (and the government shutdowns) caused unusually large and rapid swings in demand, as well as disruptions in the ability to supply goods and services.’

In a recent article ‘Are price controls the solution to inflation woes?’ Simon Youel made a very interesting point in relation to price controls: ‘With consumer price index (CPI) inflation rising to a 10 year high of 5.1%, on Thursday the Bank of England became the first of the big central banks to raise interest rates since the start of the pandemic.

The Bank did so despite its repeated admission that raising interest rates will do little to address the supply side drivers of the inflation we’re currently experiencing. … Price regulations were utilised to manage inflation in post-war China… [and also] how price controls were remarkably effective in Western countries like the US and the UK in another time of crisis: the Second World War. …by the introduction of the General Maximum Price Regulation in April 1942, which put a ceiling on how much sellers could charge based on the highest charged price a month before.’

Similarly, at home, the IMF programme should be revised from its hawkish stance to do the usual and that is to increase both policy rate and taxes to deal with macroeconomic instability, which clearly is also determined by greater global and local market failures during the pandemic. It requires a balanced policy approach of monetary tightening, and administering greater price controls to both curtail inflation and keep economic recovery on track and more inclusive.

The government should focus on playing a greater role in terms of bringing meaningful economic institutional reforms to attract foreign direct investment, rather than using the channel of policy rate hike, as also a tool in addition to dealing with inflation, to attract foreign portfolio investment, especially when greater monetary tightening globally would already mean greater competition for borrowing resources, and the higher cost of capital putting larger pressure on debt sustainability for developing countries like Pakistan.

In the case of Pakistan, price controls should also mean greater intervention in the foreign exchange market, necessitating need for adopting such exchange related polices as by Turkey recently to overall rationalize downward the cost of local currency against the US dollars, so that the current heavy impact of imported inflation could also be reduced.

Moreover, such interventionist measures by the government would help reduce the imprint of ‘greed’ or unwarranted profit margins by global and local suppliers. These will also help dilute the inflation-causing effects caused by a natural lag in supply recovery as the pandemic wanes and demand continues to recover. The IMF programme and overall policy should be adjusted accordingly if inflation is to be checked properly along with ensuring that economic recovery continues, and in an inclusive way.

Already, the growth outlook looks less attractive for less-developed countries, as highlighted by a Guardian article ‘Developing countries at risk from global economic threats, says World Bank’, while reflecting on the recently released Global Economic Prospects report by World Bank: ‘“At a time when governments in many developing economies lack the policy space to support activity if needed, new Covid-19 outbreaks, persistent supply-chain bottlenecks and inflationary pressures, and elevated financial vulnerabilities in large swathes of the world could increase the risk of a hard landing,” the report said. …“Deep debt relief is needed,” [President of World Bank] Malpass said.

“If we wait too long it will be too late and it won’t be successful.” …Growth in emerging and developing economies was expected to drop from 6.3% in 2021 to 4.6% in 2022 and 4.4% in 2023, leaving output 4% below its pre-pandemic trend.’

(The writer holds a PhD in Economics from the University of Barcelona; he previously worked at the International Monetary Fund)

He tweets@omerjaved7

Copyright Business Recorder, 2022