For many years people did not think too much about inflation in general in their daily conversation. Now discussions on inflation are in the forefront as higher prices are putting pressures on people's budget across the globe including Bangladesh. In most countries, inflation is now running at its highest rate in decades. In the US and the EU, inflation is close to 10 per cent. The last time that this was the case was in the early 1980s. According to the Guardian (August 4) the UK annual inflation rate could go up to 15 per cent by the start of 2023; more recent estimates put the inflation figure for the UK at 18 per cent or more in 2023.
Now the policy challenge for the US Federal Reserve and the European Central Bank (ECB) is to return to the 2 per cent target rate. At this year's Jackson Hole Economic Policy Symposium meeting held from August 25-27, Federal Reserve Chairman Jerome Powell set the stage for responding to the inflation crisis.
The Jackson Hole Economic Symposium is an annual event sponsored by the Federal Reserve Bank of Kansas City since 1978. Every year, the symposium focuses on an important economic issue that faces global economies. The 2022 Symposium focused on the theme "Reassessing Constraints on the Economy and Policy". The Symposium was attended by international central bankers, Federal Reserve officials and other policy makers and academics.
Powell delivered his policy speech on August 26 and understandably inflation remained the overwhelming factor and was mentioned 44 times in his speech. He said "The Federal Open Market Committee's (FOMC) overarching focus right now is to bring inflation back down our 2 percent goal". He then added "Price stability … serves as the bedrock of our economy. Without price stability, the economy does not work for anyone".
In essence, Powell invoked Paul Volker, the Federal Reserve Chairman from 1979 to 1987, to reemphasise the principal mission of central banks to keep inflation under control.
Powell also warned that "Reducing inflation is likely to require a sustained period of below-trend growth….;.some softening of labor market conditions…also bring some pain to households and businesses…But failure to restore price stability would mean far greater pain."
Powell's message was clear that central banks must not waver from interest rates hike and historical lessons strongly against premature loosening of policy. If necessary, he opined, we would go beyond the measures adopted by former Federal Reserve Chair Paul Volker (1979-87) in the 1980s to fight inflation. Volker raised the federal funds rate to 20 per cent in June, 1981. His policy measures produced two massive recessions with national unemployment rate rising to 10 per cent.
Monetary tightening is widely used at lowering the level of trend inflation, not just stabilizing inflation at target. But the use of such a monetary policy instrument most of the time results in a recession to shift the inflation dynamics lower.
Gita Gopinath of the IMF told the meeting that the IMF "significantly underpredicted the recent rise in global inflation" -- the reasons for which the IMF did not yet fully comprehend. She further added "our understanding of the causes of the global inflation surge is still evolving".
It is now generally agreed that the current inflationary surges do not reflect excess aggregate demand but the failure of aggregate supply to keep pace with the post-pandemic surge in aggregate demand pushing up prices. But that surge in aggregate demand now has faded but deficient aggregate supply continues. It is not just that prices are going up because supply is constrained but prices are also going up over concerns that the Ukraine war will disrupt future supply. Therefore, inflation outcomes are likely to be influenced by structural changes stemming from both domestic and external factors.
At the meeting, Agustin Carstens, the General Manager of the Bank of International Settlement (BIS) which serves as a bank for central banks, pointed out some of the longer-term structural shifts at work in the inflation surge. He also, as mentioned earlier, said that the current inflationary surge was not driven by demand but was the result of supply side factors. These factors are likely to exert influence which means inflation will continue to persist.
He also said that "We are used to viewing the economy mainly through the lens of aggregate demand, with supply assumed to adjust smoothly in the background. But we need a more balanced approach. Signs of fragility in supply have been ignored for too long. Recent events have shown the danger of doing that".
Carstens further added that " the global economy seems to be at on the cusp of a historic change as many of the aggregate tailwinds that have kept a lid on inflation look set to turn into headwinds. If so, the recent pickup in inflationary pressures may prove to be more persistent".
While Carstens called for a more balanced approach to policy making at a time of longer term structural shifts in the global economy with special emphasis on stimulating aggregate supply and to recognise the limits of demand side policies, he failed to mention anything about surging profits and rampant price-gouging by energy companies. In fact, the current inflation crisis has provided an opportunity for further enrichment of the financial elite. Some studies in the US found that 60 per cent of the increase in inflation was going to corporate profit indicating there is a profit inflation spiral.
Also, another factor that has contributed to increasing supply constraints has been the rising financialisation over the last few decades and that also helps the financial elite to accumulate more wealth through channelling their investment into non-productive speculation in financial assets rather than in productive investment in the real economy.
Inflation is a general rise in prices. It is owners of capital, not workers, who decide the price to charge for goods and services produced by workers. It is now generally agreed that most markets in capitalist market (politically correct term is free market) economies are highly concentrated.
Monopoly capital can pursue the highest rate of profit that can be sustained over the long run. The monopoly pricing mechanism, therefore, in a period of prolonged stagnation, as happened in the 1970s, can set off an inflationary process. In fact, lower-output and higher prices is also the textbook monopoly pricing behaviour.
More importantly monopolists can effectively frustrate the government's anti-inflationary policies. When the government uses fiscal and monetary policy tools to curb inflation, monopolists by using their market power still can raise prices even when they face declining demand.
Economists at the Federal Reserve Bank of Boston recently published a report which concludes "the increase in industry concentration over the past two decades could be amplifying the inflationary pressure from current supply chain disruptions and tight labour market". The authors, it is be noted, are not arguing that monopoly power causes inflation, but it is "an amplifying factor" that allows companies to pass on more of the costs of supply shortages, energy shocks, and labour market tightness.
Yet, Carstens following Powell's message reiterated that "central banks should indicate that they will stay the course and maintain tight monetary policy as long as inflation remains high…even if it means a sharp cooling of the economy and rise in unemployment".
Federal Reserve Chairman Jerome Powell's pledge to use sharp rises in interest rates to slow down economic growth in order to drive up unemployment rate to combat the inflation surge appears to be impacting on the market. The official unemployment rate in the US went up to 3.7 per cent in July from 3.6 per cent that remained constant over the previous three months. But this rise in the unemployment rate was most likely due to the number of workers re-entering the labour market as reflected in the rise of the participation rate from 62.1 per cent in June to 62.4 per cent in July.
Also, inflation dropped by 0.6 percentage point from its June peak of 9.1 per cent to 8.5 per cent in July on a year over year basis offering some hope that inflation is cooling down. The federal Reserve is expected to raise its benchmark interest rate by another 0.50 to 0.75 percentage points when it meets later this month. At the very beginning of this month Loretta Mester, President and Chief Executive Officer of the Federal Reserve Bank of Cleveland and a voting member of the Fed policy setting committee said the central bank is likely to raise interest rates above 4 per cent by 2023 and hold them at that level. At the beginning of this year the key Fed rate was close to zero.
The US Federal Reserve's policy to raise interest rates has now resulted in a monetary tightening in developed countries. But it is generally argued that a credible central bank can reduce inflation with less output loss, but that is not the case that we observe now as the US, the UK and the EU, all are likely to be heading for a recession in late 2022 to early 2023.
Meanwhile, inflation in countries in the Global South including Bangladesh has also risen markedly. This surge in inflation with increased volatility is a major turning point in macroeconomic conditions, creating greater challenges for policy makers in these countries.
This rising and volatile inflation has come at a very challenging time for developing countries like Bangladesh when these countries are struggling to recover from the pandemic. Global inflationary pressures have intensified further due to the US led NATO proxy war against Russia in Ukraine and sanctions against Russia causing the rise in global food and fuel prices, particularly hurting many developing countries like Bangladesh.
Monetary tightening by the US Federal Reserve could generate adverse spill overs for developing countries causing domestic currency depreciation, rising current account deficits, declining foreign exchange reserves and capital outflows fuelling further rise in inflation.
It is argued that there is a negative relationship between the openness of the economy and the rate of inflation because the fluctuations in domestic demand (i.e. price levels) are absorbed by changes in the level of imports rather than impacting on the domestic price level. The basis of such a hypothesis is the monetary theory of the balance of payments. But the necessary conditions for the operation of this adjustment mechanism do not exist in the majority of developing countries. That leaves developing countries to use monetary policy instruments to deal with inflation.
In fact, under US President Donald Trump, the US launched a series of attacks on the multilateral open trading system under the auspices of the WTO. His attack was particularly focused on efforts to undermine the Dispute Resolution Body - the WTO's mechanism for enforcing its rules. By doing so, Trump has undermined the very foundation of the global open trading system.
President Joe Biden, in practice, is also continuing with protectionist trade policy pursued by Trump. The US still remains world's largest trading nation. Therefore, an increasingly inward looking trade policy pursued by the US as well as an ever expanding sanction regime deployed against a number of commodity exporting countries including Russia are creating serious obstacles for countries in the Global South including Bangladesh to effectively deal with rising inflation using the trade mechanism.
It is now increasingly becoming clear that with a weak and fragile post pandemic recovery process and limited macroeconomic policy space, rising inflation will further constrain many developing countries' capacity to stimulate growth and reduce poverty. Therefore, central banks in developing countries including Bangladesh need to recognise that under the prevailing circumstances, inflation is becoming the main focus of monetary policy. Therefore, the credibility of monetary policy has become of utmost importance.
muhammad.[email protected]
