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The Financial Express

Inflation, productivity & macroeconomic stability

| Updated: September 23, 2022 20:42:35


People are trying to purchase subsidised food items from a truck run by Trading Corporation of Bangladesh in Dhaka 	—FE File Photo People are trying to purchase subsidised food items from a truck run by Trading Corporation of Bangladesh in Dhaka —FE File Photo

Since the second quarter of this year, inflation has been on the rise globally, driven by higher energy and food prices, persistent supply chain disruptions and tight labour markets in major developed countries. The US Bureau of Labour Statistics reported last Tuesday (September 13) that the consumer price index (CPI) rose 8.3 per cent in August compared to a year earlier, down from 8.5 per cent in July and 9.1 per cent in June this year-- the highest recorded US inflation rate over the last 40 years.

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. According to Eurostat, the European Union's (EU) statistical office, the Consumer Price Index (CPI) in the 27 member countries in the EU went up by 9.8 per cent in July this year relative to a year ago and 16 states were above this mark. Again, baltic states are the front runners in this respect, with inflation above 20 per cent.

Food and fuel are the main drivers of this inflation, reflecting supply constraints. Inflation continued to climb through August, albeit a little more slowly. But the situation varies from country to country. Rising inflation, interest rate hikes and a stronger dollar are reminiscent of the case in the 1980s, a decade that saw a wave of developing economies going through sovereign debt crises. This year has already seen Sri Lanka default, and markets have already begun to price risks of further crises among some of the heavily indebted debtor countries.

The current phase of rising inflation in developed economies, especially in the US, is of significant concern for developing economies. The rise in inflation will lead to rising interest rates, which will subsequently push the bond yields upward, causing developing countries to pay higher interest rates in the debt market. Also, the US economic recovery can result in a vast outflow of portfolio investments from these countries, causing massive financial sector instabilities. As such global economic recovery in general and the US economic recovery, in particular, may prove detrimental to a developing country like Bangladesh under the current global economic climate.

It is well recognised that structural shifts in the global economy resulting from the disruptions in global supply chains due to the pandemic are contributing to the current spate of inflation, notwithstanding the war in Ukraine. Moreover, the pandemic and the US-led NATO proxy war in Ukraine against Russia have also acted as a catalyst in causing fundamental shifts in global economic relations, thus further accelerating global supply constraints.

It is 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 insufficient aggregate supply continues. Moreover, it is not just that prices are going up because supply is constrained. Still, the war has also provided a further significant external shock to developing countries, further constraining aggregate supply.

Christian Sewing, CEO of Deutsche Bank, recently cited disrupted global value and supply chains, along with a bottleneck in labour markets and a shortage of gas and electricity leading to soaring costs, as key reasons for high Eurozone inflation. He added, "the longer inflation remains high, the greater the strain and higher the potential for social conflict:".

The current inflation surge has been largely due to widespread price level shocks resulting from supply bottlenecks and anchored inflation expectations. In most countries, inflation is now at its highest rate in decades. In the US and the EU, inflation is close to 10 per cent. The last time this was the case, it was in the early 1980s. In the UK annual inflation rate is forecast could go up to 18 per cent or more in 2023. Price increases in North America and Europe developed countries threaten to plunge millions into poverty.

Inflation, or a general increase in prices, is a problem that often afflicts the market economic system and directly impacts the standards of living for wage and salary earners in all market economies. They have to suffer ifThey have to suffer if they cannot raise wages and salaries at least as fast as inflation raises prices.

But in almost all developed countries, incomes are not keeping pace with price increases. In Germany, for example, wages have gone up by 2.9 per cent, with prices rising by 8.5 per cent. In fact, if inflation raises prices faster or more than wages, that represents a redistribution of income from labour to capital or more precisely from employees to employers.

According to a poll conducted in France, Germany, Poland and the UK, the rise in the cost of living has become the most critical issue in all four countries. One in every five respondents said that they had to dip into savings to survive. The majority also expects social unrest in the coming months, as was alluded to by the CEO of  Deutsche Bank.

This rising and volatile inflation has also come at a very challenging time for developing countries like Bangladesh when these countries are struggling to recover from the pandemic. A significant slack in the domestic labour market remains with higher poverty levels relative to 2019 in these countries. The pandemic has also pushed debt levels higher, leading to higher risks of debt distress.

Monetary tightening by the US Federal Reserve could generate adverse spillover for developing countries causing domestic currency depreciation, rising current account deficits, declining foreign exchange reserves and capital outflows fuelling further inflation. A decrease in the value of the domestic currency, depreciation, will contribute to inflation or, more precisely, imported inflation. In terms of imported inflation, the exchange rate has a more significant impact on inflation, passing through the prices of goods and services that are exported and imported or otherwise known as tradable goods and services.

Amid a relatively weak economic recovery process, rising food and fuel prices in developing countries like Bangladesh are pushing millions more into poverty while exacerbating income inequality further. With limited macroeconomic policy space, the rise in inflation will constrain many developing countries to reduce poverty rates.

Developing countries, including Bangladesh, are now facing twin challenges of economic recovery from the pandemic and rising inflation. Monetary policy also does not operate in a vacuum.

Therefore, developing countries like Bangladesh need to ensure fiscal sustainability, without which inflation expectations are unlikely to remain well anchored.

It is to be noted that inflation in the past was reduced using means other than simply relying on monetary policy alone. For example, US President Richard Nixon imposed a "wage-price freeze" in 1971, and US President Franklin Roosevelt used rationing in the early 1940s. They provide alternative anti-inflationary policies. But as these policies are considered unfavourable to owners of capital, they are very rarely used nowadays.

Inflation is, after all, an economic policy phenomenon which requires the continuation of a policy mix, both fiscal and monetary, to address the issue. Fiscal policy is geared to protect incomes from price escalation while allowing monetary policy to ensure that inflation expectations remain well anchored. Therefore, monetary policy must manipulate interest rates towards neutral levels.

The concept of the neutral interest rate is a useful one. It is the real interest rate (interest rate adjusted for inflation) that is neither stimulatory nor contractionary. This objective can be achieved with a series of upward adjustments in the interest rate, which most of the time can lead to a recession to push the inflation trend down leading to stabilising inflation at target. Therefore, it is argued that such a policy initiative will help keep inflation expectations anchored and eliminate supply shocks.

A more sustainable balance between demand and supply is needed for inflation to return to the target level of 2 per cent. So, it is suggested that a higher interest rate will help achieve this through moderating growth in aggregate demand.

It is now widely accepted that the current surge in inflation has been due to large and widespread price shocks mostly emanating from the supply side. This is because higher prices for inputs that are widely used across the entire economy such as labour and energy products can have a macroeconomic impact on aggregate supply.

Along with energy products, the costs of other imported input products also contribute to rising total costs of production through the cost-push channel, negatively influencing aggregate supply. If the supply shock is sufficiently large or persistent, it not only causes inflation but can noticeably reduce both the current and potential levels of output.

Under the current economic circumstances, there is a limit on what can be achieved through managing aggregate demand. An increased focus on aggregate supply is needed now, and it is increasingly becoming so. In the long run, productivity growth is the most important factor that stimulates aggregate supply. Productivity, in economic terms, is how much output can be produced with a given quantity of inputs, especially labour. One measure of this is output per worker. Productivity growth has now become the principal means to rein in the current inflationary surge.

In the short run, aggregate supply responds to higher demand by increasing the use of current inputs in the production process. But in the long run, aggregate supply is not affected by the price level and is driven only by improvements in productivity. However, from the Keynesian theoretical perspective, long-run aggregate supply is still price-elastic up to a certain point; beyond that point, supply becomes insensitive to changes in price.

Agustin Carstens, the General Manager of the Bank of International Settlements (BIS), in his paper presented at this year's Jackson Hole meeting held about three weeks ago, wrote: "Low productivity growth was a key warning sign. In advanced economies, it plunged during the Great Financial Crisis (GFC) and never fully recovered, part of a longer decline going back at least to the late 1990s. In emerging market economies, the productivity boost from integration into global networks and structural reforms proved to be fleeting. The post-GFC slowdown has been the steepest and most prolonged of the past three decades".

For a developing country like Bangladesh, many of the challenges now facing the country could be made easier to deal with by stronger growth in productivity. More robust productivity growth means a bigger economic pie and better living standards. But, more importantly, in the current phase of an inflationary surge, it can also put downward pressure on prices and inflation. Therefore, by creating downward pressures on inflation, Bangladesh will increasingly achieve macroeconomic stability, which is necessary to stem price rises and encourage welfare-enhancing growth.

Recent trends in productivity growth in Bangladesh have not been encouraging relative to most of the comparable countries in Asia. The strategic challenge for Bangladesh is to do what reasonably can be done to lift its productivity growth. 

Stronger productivity growth will generate increased revenue for the government, thus enabling the government to fund many services that the public value. Therefore, to achieve improved productivity Bangladesh will need to include an enhanced level of skills and education among workers, technological advancements and increases in capital.

The economic circumstances prevailing around the world, including Bangladesh, now call for a more balanced approach to policy formulation recognising the limits of aggregate demand management. It will also be important to put in place policy initiatives to increase aggregate supply by stimulating productivity growth.

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