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Wednesday, 23 June 2021

Containing inflation fears

With the continued decline in average incomes in 150 countries, a hike in inflation should not be a concern, if expectations are adequately managed and self-fulfilling prophecies are avoided

Mahmoud Mohieldin , Wednesday 10 Mar 2021
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A possible hike in inflation after years of maintaining low rates has been the subject of heated debate as one of the repercussions of the current Covid-19 pandemic and attempts to contain it. 

The shrinking world economy with a negative growth rate of 3.5 per cent in 2020 together with the decline in global inflation and the subsequent decrease in interest rates have encouraged governments, especially in developed countries, to increase public spending. The latest such increase was the recent approval by the US Congress of an additional $1.9 trillion package of spending to be pumped into the pandemic-stricken American economy. The package was approved after the US federal budget registered a deficit of $3.1 trillion last year due to spending on Covid-19 response.

Heavyweight economists such as Nobel Laureate Paul Krugman and former US treasury secretary Larry Summers have agreed to a large extent on the necessity of such spending. However, Krugman has described it as a rescue measure, while Summers has said it is a stimulus. The difference between the two descriptions is huge. If the spending is meant for rescue and relief, it should not be viewed in terms of economic considerations focused on the output gap requiring to be bridged. Krugman’s opinion reduces the potential for the spending having significant inflationary repercussions despite the volume of the rescue package. 

On the other hand, Summers believes that the package presented by the Biden administration is bigger than the amount needed to close the output gap and that it will increase inflationary pressures in a way that may push the US Federal Reserve, the US Central Bank, to increase interest rates earlier than expected, driving the economy into recession. This would be contrary to the purpose of the entire policy.

There are undisputed items of spending that both the Krugman and Summers camps agree on, such as helping to make vaccination against Covid-19 available to all, ensuring the reopening of schools, and aiding the unemployed and government and municipal administrations. They differ, however, on cheques being paid to millions of people without these being in return for work or to compensate them for possible losses or damage.

Summers estimates that about $1 trillion of the latest package is unjustified public spending that will go to waste or be used for gambling operations on stock-market bubbles, as was the case with the money that was pumped into the shares of the bankrupt GameStop company.

In assessments of the economic models, such as those on which the International Monetary Fund (IMF) Research Chief Economist Gita Gopinath has referred to in a recent article, unemployment in the US has fluctuated between 10 per cent in 2009 following the global financial crisis and 3.5 per cent in 2019 before the coronavirus crisis without affecting inflation rates. Inflation remained stable at low rates that did not compel the Federal Reserve to raise interest rates. 

According to these models, a rise in inflation should not be of concern, especially if it is supported by structural factors and supply chains of cheap goods thanks to globalisation. With the continuing decline in average incomes in 150 countries this year to less than they were in 2019, inflation will remain on the decline, driven by international trade.

Supporting the possibility of continued low inflation is the rise in the contribution of the technological component to production, preventing the transformation of any rise in wages into an increase in the prices of final products.

However, inflation is not only determined by supply and demand. Expectations also play a vital role, especially with the rise in risk, the lack of trust and the uncertainty shrouding the unprecedented crisis of the pandemic. 

Former president of the German Bundesbank Axel Weber has argued that the fire of negative expectations about inflation and their effect on the possibility of raising interest rates on short-term debt is not without some smoke. The speculation is fuelled by the increasing deficit of central governments to more than 11 per cent of global GDP, which exceeds three times the average deficit over the past 10 years. 

The deficit has raised central bank budgets and financial statements by 13 per cent over the past year. What has preserved stability has been the fact that masses of savers and investors in government securities have accepted a negative return, or a close to zero return on their investments. If they were to rethink their decisions, the value of currencies would decrease, and consequently inflation would rise.

Weber also pointed to two other factors. The first is that if travel and movement restrictions are eased, the price of services will increase due to their present weak supply, with restaurants, airlines and hotels perhaps not reaching adequate operational capacities as quickly as expected in Europe, for example.

The second factor, more prevalent in developing countries, is the failure to measure inflation accurately because the goods and services used to measure it are not those that are highest in price and more susceptible to successive changes in demand and price.

The opposing views of economists about the possibility of a rise in inflation are fed by the speculation that moves financial flows within and out of countries. Here, the idea of a middle-income trap is important, by which I mean the middle-income countries (MICs) that make up one third of the world’s economies, comprise 75 per cent of the global population, and in which 62 per cent of the world’s poor live, according to World Bank data. 

These countries do not enjoy the advantages that advanced economies have, such as cheap borrowing in their local currencies without the exchange rate risk. The middle-income trap countries do not benefit from the advantages of cheap and facilitated borrowing from international development institutions, which the poorer and lower-income countries benefit from, always assuming that they have the capability to meet their financing needs through local private-sector investment and the international financial markets.

Countries caught in the middle-income trap should take early precautions against the impact of sudden changes in international interest rates targeting short-term securities in order to contain speculation about inflation that might be associated with changes in exchange rates and increases in the actual cost of international loans, particularly if their credit ratings change.

It has been seen that the G7 and G20 countries have tended to disregard the middle-income countries when it comes to international aid to combat the coronavirus pandemic. The G20 initiative to freeze debt-service payments within the framework of Debt Service Suspension Initiative (DSSI) which will end in June, and the Common Framework for Debt Treatment are both initiatives directed at low-income countries. The MICs do not benefit from such important initiatives, although the number of people who suffer from poverty in the middle-income trap countries exceeds the number of the poor in lower-income countries. 

Ways to improve the lives of the world’s poor should go beyond futile considerations that classify countries according to misleading income brackets.

 

*An Arabic version of this article appeared on Wednesday in Asharq Al-Awsat.

*A version of this article appears in print in the 11 March, 2021 edition of Al-Ahram Weekly

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