Monday 4 July 2022

ECONOMIC CONUNDRUM - HOW TO TAME RED HOT INFLATION WITHOUT DERAILING GROWTH ?


For well over a decade Central Banks in G7 economies have been pursuing loose monetary policies (Quantitative Easing and low interest rates) to avert deflationary risks in the aftermath of global financial crisis and been wishing for inflation.  Now that they have got what they wished for, they are dreading it! The sudden spike in inflation has sent Central Bankers into a state of anxiety and they are now playing a catch-up mode.

How did we get here?

a)      Covid related supply disruptions

In March 2020, WHO declared Covid as a pandemic and this led to lockdowns in many countries and regions as a response to contain the rapid spread of the pandemic.  As a result, there was a sudden stoppage in economic activity as the duration of the lockdowns kept increasing.  To counter the adverse effect of lockdowns on the economy, Governments and Central Banks across the world adopted unprecedented measures ranging from cash support to credit concessions to fiscal stimulus, and monetary policy actions to restore stability and to keep the economy moving.  Central Banks dropped the already low interest rates to near zero as a response to the Covid shock.

As economies began to open slowly, the consumer demand bounced much quicker while production had not been fully restored.  The on-going impact of Covid in different countries meant that there was a large enough disruption in the manufacturing sector.  This led to supply chain disruption, resulting in inflation perking up.  The ongoing trade disputes are further worsening the supply chain problems.

b)      Inflation fuelled by Oil price (and other commodity prices)

Oil price, which dropped to $25/bbl during Q2/2020, recovered to an average of $70/bbl from Q2/2021 as economies opened fueling demand following successful vaccination programmes leading to a containment of the pandemic.  The Russian invasion of Ukraine in late Feb 2022, that was quickly followed up with economic sanctions on Russia, resulted in Oil prices spiraling beyond $100/bbl mark adding further fuel (pun intended) to the already rising inflation caused by supply chain disruption.

Central Banks have been behind the curve

Central Banks were cautious in their monetary policies in Q3/Q4 2021 even as inflation figures were showing a rising trend.  Their primary concern was not to derail the fragile recovery following Covid related economic decline and the expectation was that inflation would fade. Well, that didn't quite play to their expectations.


Clearly, they were behind the curve in their actions and are now pushed into a catch-up mode to contain runaway inflation, particularly in the US, where aggressive interest rate hikes are in train.  While we can expect ECB and BoE take a more moderated and nuanced approach, the cycle of rates seems to be headed higher in the near term, until of course it pushes the respective economies into contraction.

In the short-term Inflation is likely to get worse

The inflation is likely to worsen further due to the ongoing demand from labour for wage hikes to meet rising food costs, soaring energy bills, and depleted spending capacity. There have been large scale protests by Unions for wage hike as people struggle to balance their budget.  Further increase in interest rates will squeeze the spending and cause further economic pain to the already suffering masses. There is a risk of wage increase feeding into inflation while impact of rates is likely to have a lagged effect.

Some economies are having disproportionate impact of rising prices with countries like Sri Lanka, Afghanistan, Myanmar and many others facing food and energy shortages and many forced to skip meals due to lack of means. This situation is not likely to be addressed without political leadership from G-20 nations to support these economies in their economic and social hardships.

Are interest rates rises sufficient to tame inflation?

If the only tool you have is a hammer, every problem looks like a nail!

Unfortunately, this is the position of Central Banks.   While they are mandated to control inflation but have limited tools to achieve that. Monetary policies have its limitations and are not necessarily the right tool for every situation (e.g., supply chain shock).  Furthermore, monetary policies have a lagged effect on inflation. 

Increasing interest rates alone is not going to get us out of this difficult economic conundrum. If anything, aggressive interest rate hikes will lead to the recession as it will deplete demand without necessarily addressing the core issue of supply chain disruption and high oil prices.  And once the economy gets into stagflation, it will become extremely difficult to reverse it.

While the US FED is likely to pursue its aggressive interest rate actions, the ECB and BOE are likely to be more moderated in their actions as they acknowledge the limitations and unintended consequences.

What other actions would help?

Besides some action on interest rates, there needs to be a concerted action to address the following key issues, as monetary policies on its own cannot resolve the current economic situation.

·       Actions to tame Oil Price – As higher energy prices cause cost push inflation; it is extremely important that this is addressed urgently. Securing higher production from OPEC, increasing shale oil production, releasing oil reserves, and lastly rapid investment in renewable energy to reduce dependence on Oil (though this is not a short-term solution).

 

·       Supply chain disruption – Restoration of production and easing of transport and logistics are essential to control price inflation caused by supply chain disruption. Addressing this could require fiscal incentives, credit concessions and other policy support measures to support the manufacturing, and transport and logistics sector. 

 

·       Trade/Tariff barriers - This will require leadership from G-20 nations to rise above their current disputes as there is a bigger and common economic issue facing the global economy.

 

·       Essential Commodities – Release surplus food stocks to curb price inflation and channel to countries in dire need.  This would require greater coordination and leadership amongst G-20 nations.

 

·       Resolve political impasse – While this is the most obvious cause for the runaway spiraling of inflation, this is also the most difficult one to resolve. The significant economic shock to many countries reliant on commodities imports following Russia’s invasion of Ukraine causing economic pain is telling.  With each passing day, the situation is getting further worse with ratcheting up of the political rhetoric on both sides.  Commodity prices can remain elevated for a considerable period of time, despite monetary policy actions, if the political impasse continues.  JP Morgan estimates that under an extreme scenario, Oil price could even get to $380/bbl.  That would be catastrophic for many economies reliant on oil imports.

 

In Summary

The issue of high inflation cannot be fully addressed by aggressive interest rate hikes alone.  Despite this, Central Banks are mandated to curb inflation with limited tools at their disposal. They will act with the only tool that they have i.e., monetary policy actions as do not have much else to demonstrate that they are acting on inflation.

Political leaders need to step up to the challenge and work together to address this global challenge of looming stagflation. The underlying causes of low growth, and high inflation need to be addressed that requires concerted action on restoring supply chain, an interim agreement on Trade and tariff and a firm resolve to address with Political conflicts.

We are in for a scorching summer, one that is not just due to the heat alone. The red hot inflation is about to get hotter!

 

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