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Global inflation crisis: the risk of recession looms large

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Inflation has come back faster, spiked more markedly and appears to be more persistent than leading central banks initially thought possible. Latest available data (March 2022) on inflation tell us that annual consumer price inflation as measured by the consumer price index (CPI) stands at 8.5 per cent in the US, 7 per cent in the UK,  7.5 per cent in the Eurozone and 16.7 per cent in Russia. Also, countries such as Argentina recorded 52.3 per cent and Turkey 61.1 per cent rise in their price levels. In Bangladesh and its neighbour India official inflation rates stand at 6.22 and 7 per cent respectively.

Meanwhile, Andrew Bailey, Governor of the Bank of England (BoE) sent a dire warning that before the end of the year the UK faces dual risks of both a recession and inflation above 10 per cent. The UK inflation is now forecast to peak above 10 per cent in the fourth quarter of this year. Bailey further added this would cause further hardship for many people, particularly those on the lowest incomes.

Andy Haldane, former chief economist of the BoE warned that inflation could go even higher than 10 per cent predicted and could be with us for years. Concerns about the UK economy continues to hit the pound down and tumbled by almost 3 cents against the dollar on the currency market after the Governor's declaration. The BoE, however, predicts that the UK will avoid a technical recession-- two consecutive quarters of contraction but output will collapse by close to 1 per cent in the final quarter this year which will translate into a 0.25 per cent fall in Gross Domestic Product (GDP) on an annualised basis.

According to the US Bureau of Labour Statistics (BLS) the annual inflation rate  in the US slowed to 8.1 per cent in April from a 41 year high of 8.5 per cent in March. But the real outcome as published on May 12 tells that inflation in the US edged down to an 8.3 per cent annual rate in April. Despite such expected slowdown in April, inflation is unlikely to fall to pre-pandemic levels anytime soon and will remain above the Federal Reserve's target rate of 2 per cent for long time as supply disruptions and food prices remain elevated.

As inflation hit a new 41 year high in March this year in the US, there are now growing concerns that the recovering US economy might suffer significantly from the knock-off effects of sanctions imposed by the US  against Russia resulting in rise in energy prices. This will not only keep inflation climbing but could induce a recession as energy prices drive up costs for consumers and producers.

Investors in the US are increasingly becoming bearish in anticipation of global economic growth plunging to their lowest level since the collapse of Lehman Brothers during the Great Financial Crisis (GFC) of 2008. The interest rate hikes, imposed under conditions of rising inflation, now threatens to set off new financial crisis. Commodity markets are already in turmoil along with bond markets which can also spark a systemic crisis.

In fact, Wall Street, together with other stock markets around the world, has continued fall under the impact of rising interest rates to combat rising inflation with the resultant slowing of global economy. It is now widely viewed that rising inflation and interest rates could have far reaching effects, negatively impacting domestic activity, asset prices, credit quality and financial situation.

There are also growing fears of a significant slowdown in China as it deals with the spread of the latest Covid-19 outbreak to bring it under control with exports falling to their lowest level in two years in March this year. There are growing indications that German and French manufacturing output are also falling. All these indicate slowing down of global economic activity.

This current inflationary surge is not only limited to developed rich countries but have also hit  developing countries. The factors driving price levels up are not uniform across countries, especially between developed and developing countries. So, also the pandemic induced economic slowdown and recovery patterns differ markedly. While overheating is diagnosed as the major contributing factor to the current inflationary surge in the US and other developed economies, it  does not apply to many developing countries where fiscal and monetary stimulus in response to Covid-19 was limited. In fact, many developing countries were already experiencing decline in per capita income before the pandemic. Also, income disparity between developed and developing countries has been on the rise for a considerable period of time.

Yet, there are certain commonalities that could be seen across developed and developing economies in the current phase of rising inflation. They include increase in commodity prices, now further exacerbated by the Russia-Ukraine conflict along with the US sanctions against Russia, supply bottlenecks with skyrocketing transport and input costs and rising food prices. Developing countries, however, are also experiencing currency depreciation (largely due to lower foreign capital inflows) further contributing to inflation. In fact, the passthrough from exchange rates to prices tend to be faster and more pronounced in developing economies.

If we look at the three key macroeconomic indicators-- GDP, inflation and unemployment in developed countries like the US and EU countries and developing countries, they do not tell us good news at this point in time. There are often good news and bad news - high GDP growth accompanied by high employment but also higher inflation. But keeping inflation low comes with slow economic growth with higher unemployment.

The Federal Reserve and other central banks like the BoE have two principal tasks to perform-- keep inflation under control and maximise employment. Therefore, a more timely robust policy response to rising price levels i.e., inflation from major central banks will require a substantial monetary policy response which involves for them to raise interest rates and tighten other aspects of monetary policy.

The Federal Reserve and other major central banks plan to raise interest rates throughout 2022. It is widely expected that the Federal Reserve will raise interest rates above 2 per cent by the end of the year. To deal with inflation more effectively, the Federal Reserve will end quantitative easing (QE) bond purchases and will start selling assets which is termed as quantitative tightening (QT) later in 2022. 

The Federal Reserve already raised its interest rates by a half a point  to 1.0 per cent, its biggest increase since 2000 and its Chair Jay Powell said more such hikes were on the way. The BoE also raised its interest rates to 1 per cent from 0.75 per cent. This was the BoE's fourth rate rise since December 2021. It is likely that interest rates would be hitting 2.5 per cent by mid-2023 in the UK. Also, like in the US, the BoE is considering selling bonds purchased under QE. So far, no major central bank has yet conducted active sales of government bonds.

Now the fear is that major economies like the US, the UK and others are likely to slide into stagflation as experienced in the 1970s. Stagflation is a period of stagnant economic growth combined with high inflation and high unemployment, while recession is a period during which the economy shrinks. It is commonly defined as two successive quarters of declining GDP. Recessions occur periodically as part of typical economic cycles of expansion followed by  contraction averaging less than a year. But during a period of stagflation, all three macroeconomic indicators go in the wrong direction at the same time.

Stagflation in the 1970s was largely attributed to two factors - supply shocks  as reflected in quadrupling of oil prices during the early 1970s and fiscal policies that caused increased money supply. The period was marked by several recessions. It was primarily dealt with by aggressively raising interest rates going up to 20 per cent to rein in inflation which hit 14 per cent in 1980. While such a policy drove the economy into recession but eventually led to lower inflation and unemployment.

While fears of stagflation are rising, it is unlikely that developed economies like the US and Eurozone economies will be susceptible to going into a negative spiral but certainly inflation will pick up. As the Federal Reserve starts withdrawing pandemic aid and lifts interest rates, it is preparing for a soft landing where it will prioritise promoting growth over defeating inflation. In doing so the Federal Reserve may even raise its inflation target above 2 per cent in an effort to claim victory over inflation.

More importantly economists do not expect a return to the 1970s because there are significant differences between the backdrop of 1970s and today. Also, in the 1970s the Federal Reserve's tendency to do too little too late to deal with inflation is not the case anymore now. It is also to be noted that the interest rate hikes under conditions of rising inflation could also spark off a new financial crisis. In fact, some economists consider that now a financial crisis is more likely than recession.

Meanwhile, developing countries like Bangladesh are facing their unique set of problems in dealing with the current inflationary surge. There is little evidence to suggest that the inflationary pressure in Bangladesh is driven by overheating the economy in the aftermath of policy stimulus given the size of it  nor inflationary expectations are deeply anchored. As such monetary policy actions may prove to be less effective.

Bangladesh as a food importing country will face skyrocketing food prices partly contributed by the ongoing Russia-Ukraine conflict and also US sponsored wars in the Middle-East other parts of the world, especially in Africa. The FAO Food Price Index (FFPI) is a measure of the monthly change in international prices of a basket of food commodities. The FAO Food Price Index averaged 159.3 points in March, up 12.6 per cent from February when it had already reached its highest level since its inception in 1990. Food accounts for a much larger share of average household's total expenditure in Bangladesh. Furthermore,  higher energy prices will also feed into food prices through increased transport and input costs.

Already Bangladesh is experiencing significant balance of payments (BoP) difficulties with rising import bills. In response to the BoP crises the Bangladesh currency taka depreciated. Also,  such a depreciation of the taka relative to the US dollar indicates that the taka is adjusting for inflation. The annual inflation rate in Bangladesh rose to 6.22 per cent in March this year from 6.17 per cent in the previous month. It was the highest inflation rate since October 2020. This was largely driven by prices of food items. Prices of food items rose by 6.34 per cent relative to prices of non-food items by 6.04 per cent in March.

From July 2021 to February 2022, the current account deficit stood at US$12.83 billion. Therefore, Bangladesh risks importing inflation from major importing countries. Bangladesh will also face increased funding costs as leading central banks are tightening their monetary policy to stem price rises in their own countries.

It is to be  noted that the deepening global economic crisis as reflected in rising inflation in countries around the world is not some  theoretical construct. In the coming year or even in years ahead,  we are likely to see growth slowing down considerably and the spectre of recession starting to loom large.

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