Rising inflation and interest rates in the US and the Global South

| Updated: July 29, 2022 20:44:21

Rising inflation and interest rates in the US and the Global South

Inflation has proved to be anything but transitory in the US as was claimed by the Federal Reserve 2021. Even earlier in 2022, US Treasury Secretary Janet Yellen also opined that US inflation would be short lived and temporary. But the inflation rate in the US has been accelerating hitting 9.1 per cent in June, 2022, the highest since November,1981 from 8.6 per cent in the previous month.

This rapid rise in inflation rate in the US is sending shock waves through the global economy and came in well above market expectations of an 8.8 per cent rise. Reflecting broader market sentiments, economists have put an interest rate hike of 100 basis points (1 percentage point) on the table for the meeting of the Federal Reserve to be held at the end this month.

The escalation of US inflation that commenced in August-September 2021 has continued to worsen. The emerging factor of growing importance now is the continuation of inflation trends throughout 2022 giving rise to emerging "inflation expectation". This means consumers will purchase early items they do not need now or had not planned to buy, in order to avoid future price hikes further adding to demand pressures notwithstanding the existing and future supply constraints. Overlaid on this scenario is another factor, widespread price gouging by US corporations with concentrated market power that enable them to raise prices beyond normal demand and supply.

Meanwhile, the Bank for International Settlements (BIS), the umbrella organisation for the World's central banks has called for an escalation of interest rate rises to tame inflation. The call was made in the BIS annual economic report issued last month. The report further added that "Given the extent of the inflationary pressures unleashed over the past year, real policy rates will need to increase significantly in order to moderate demand". That means policy rates must remain above inflation increases.

IMF Managing Director Kristalina Georgieva on the eve of the G20 Finance Ministers' meeting held in the middle of this month forewarned that while there was a synchronised tightening of monetary policy by central banks, more was required and they would "need to continue to tighten monetary policy decisively". She further added, "Without action, these countries could face a destructive wage-price spiral". More alarmingly she also said it was "going to be tough 2022 - and possibly tougher 2023, with the increased risk of recession".

As the inflation problem has worsened and broadened beyond food and fuel prices, policy makers at the Federal Reserve are more likely to scale up the pace of interest rate hikes to rein in inflation. The federal Reserve's policy aim is to manage money supply in a way that maintains price stability and that usually means fighting inflation, which is assumed to be caused by too much money floating around. Also, by bringing inflation under control will ensure that price rises do not lead to increased wage demands thus forestalling a wage-price spiral.

It is now clearly apparent that later this month (July), US interest rates are expected to jump for a second time and that will have serious implications for the economic recovery of countries in the Global South such as Bangladesh. The Federal Reserve, as mentioned earlier, could push its base rate up by a full percentage point, ending 15 years of very cheap money intended to promote growth. In fact, the Federal Reserve may even be contemplating further rises in the near future.

Many countries in the Global South are already broke and the deepening crisis in Sri Lanka is having a heavy impact on these countries. Also, the recent debt default by Sri Lanka has some concerned that further defaults may occur. According to the IMF, four Asian countries which include Bangladesh, Laos, Maldives and Pakistan are likely to be moving into a similar trajectory like in Sri Lanka.

In fact, with reserves falling and rising inflation as well experiencing the twin deficit, the Bangladesh government has acted fast to curb non-essential imports, relaxing rules to attract increased remittances and reducing foreign trips for its officials.

IMF Managing Director Georgieva already said during meetings of the G20 finance ministers that "Countries with high debt levels and limited policy space will face additional strains. Look no further than Sri Lanka as a warning sign". She further added that countries that could struggle are the ones seeing sustained capital outflows for four months.

Now there is great concern that when the US decides to raise interest rates further to tackle inflation, that will exert terrible impact on these economies. Economic analyst Mohammed El-Erian (President of Queen's College, Cambridge University) in a comment published in the Financial Times writes, "They now face a further tightening of global financial conditions, as well as increased dollar appreciation (because of interest hikes in the US) that aggravates their imported inflation and destabilising their debt sustainability and the domestic financial markets". Now it is becoming increasingly clear that countries in the Global South in general and highly indebted ones among them in particular are in the first firing line.

There are a number of reasons why such outcomes will eventuate. Interest rates rise in the US makes the country a more attractive place to invest leading to increased demand for the US dollar around the world pushing its price up. As the dollar appreciates, prices of imported goods and raw materials will rise as most of these are priced in the dollar. At the same time borrowing in dollar also becomes more expensive.

Therefore, the consequences for a Global South country like Bangladesh are very clear. As Bangladesh mostly borrowed in the dollar, it will have to raise domestic interest rates to help the Bangladesh taka to compete with import price rises on the one hand and on the other Bangladesh will also face massive rise in interest payments on its dollar borrowings.

It is now increasingly becoming clear that many countries in the Global South will stumble on their dollar denominated external loan repayments. IMF Managing Director Georgieva has warned that 60 per cent of low income countries are already in or near "debt distress" - an alarming threshold reached when their debt payments equal half the size of their economies.

According to the IMF, emerging and developing economies policy rates were lifted sooner, the average total rate increase has been 3 percentage points - almost double the 1.7 per cent points for advanced economies. The IMF also further adds that central banks will need to continue to tighten monetary policy decisively. This is especially urgent where inflation expectations are starting to de-anchor.

Bangladesh Bank also raised its policy rate by 50 basis points to 5.5 per cent on June 30. This is the second consecutive month the policy rate has been raised, after a 25 basis points hike in May. The central bank said that the most recent hike was meant to "manage demand side pressures". However, it is to be noted that the IMF early this year pointed out that supply constraints hurt economic recovery and boosted inflation in 2021. That situation remains unaltered into 2022.

Despite interest rate hikes, Bangladesh currency taka has been depreciating over the last few months. Such depreciations lift the price of imports, further fuelling inflation on top of the price hikes caused by food and fuel price escalations, thus contributing to the higher cost of living. The Bangladesh taka is likely to fall further as the US dollar continues to appreciate propelled by interest rate hikes in the US. Furthermore, borrowing in dollar is also now becoming more expensive. An editorial in the Wall Street Journal already warned that "sharp movements in exchange rates create uncertainty and can lead to economic and financial instability".

According the BBS, the inflation rate in Bangladesh reached 7.56 per cent in June from 7.42 per cent in May this year. This was the highest inflation rate since July 2013. With rising inflation, purchasing power of Bangladeshi consumers is declining creating a cost of living crisis. However, it is to be noted that inflation can be a sticky and slow moving variable. Also, gradually raising policy rates at a pace that falls short of inflation increases means falling real interest rates. This is difficult to reconcile with the need to keep inflation in check.

The result of rising inflation has been that while consumers are paying more, consumption is falling and making cut backs on many daily consumption items in a country where 20.15 of the population live below the national poverty line as estimated in 2019.

But according to the South Asian Network on Economic Modelling (SANEM), the percentage of the population living below the upper poverty line has nearly doubled from 20.16 per cent in 2018 to 42 per cent in 2020. The percentage of extremely poor trebled from 9.4 per cent 2018 to 28.5 per cent in 2020.  According to the UN sponsored report titled "The State of Food Security and Nutrition in the World, 2020", a total of 73.5 per cent of the people in Bangladesh are unable to afford healthy food. What is more concerning is that the trend in the number of people belonging this category shows a rising trend.

It now appears that Bangladesh's attempt at fighting inflation is unlikely to fix surging food and fuel prices in the near future. Of particular concern for Bangladesh is surging fuel prices. Bangladesh is a net fuel importing country. As fuel prices surge to record levels, it negatively impacts on fuel imports creating fuel shortages. Already Bangladesh government has introduced planned power outages to conserve energy.

Economic activity is energy transformed; without energy producing anything basically becomes impossible. Therefore, the emerging energy crisis will cause deceleration of economic growth in Bangladesh and other countries in the Global South. Petroleum accounts for 3 per cent of global GDP, if this 3 per cent of global GDP become increasingly more expensive, that will definitely have some impact on inflation. Inflation now is higher than expected and has broadened beyond food and fuel prices creating increasingly a more challenging situation. This will even impede economic recovery and lower living standards in countries in the Global South.

Many countries in the Global South are now facing serious economic challenges driven by unsustainable debt levels, rising inflation, declining competitiveness, and now also food and fuel crises on the top. More worryingly, El-Erian in his comment published in the Financial Times also dismissed suggestions that if inflation numbers started to come down, the crisis would somehow pass, pointing to "the damage already unleashed and that which is to come". In a similar vein, IMF's Georgieva told G20 Finance Ministers at Bali that they face a global economic outlook that had darkened significantly.

Under the circumstances outlined above, the US interest rate hikes to wring inflationary pressures out of the economy can deliver long distance damage to many countries in the Global South that are vulnerable to financial shocks. Among them are those that rely heavily on imported food, fuel and other commodities and that have low reserves to meet their external debt obligations. And yet, the Federal Reserve could just be taking a breath before embarking on raising interest rates several more times this year to flush out resurgent inflation in the US.

[email protected]

Share if you like