Global inflation: Aggressive monetary tightening is not inevitable

Alternatives to tightening, including global coordination, must be explored

When the United States sneezes, the rest of the world catches not a cold but pneumonia. That is the bleak message from UNCTAD’s latest Trade and Development Report.
 

America’s Federal Reserve has been aggressively raising interest rates in order to fight inflation. All other economies have had to follow suit in order to keep their currencies afloat.

The UNCTAD report cites a study that shows that 1 percentage point increase in interest rates in the US reduces gross domestic product (GDP) by 0.5 per cent in advanced economies and by 0.8 per cent in emerging economies after three years. The 3 percentage points rise in interest rates in the US post-Ukraine thus translates into a drop in GDP in emerging economies of 2.4 percentage points. 

Interest rate hikes in the US do more than derail growth in today’s world. They threaten macroeconomic stability in the developing world, thanks to the high level of external indebtedness in these economies.

The ratio of external debt stock to exports in developing economies averages 127 per cent, which is 18 percentage points above the level during the taper tantrum of 2013. The average hides the difficult situation for low-income and lower-middle income countries. 

Total debt (public and private) in emerging and developing countries was lower than today’s in 1980 when the Fed began its now-famous tightening of monetary policy in response to inflation in the US. The rise in interest rates then was sufficient to trigger a Third World debt crisis.  The report says, “Monetary tightening by the Fed thus has a considerable risk of triggering a new chain of financial crises in EMDEs (emerging market and developing economies).”

The best part of the UNCTAD report is where it challenges the notion that aggressive tightening is inevitable given the high rate of inflation in the US and elsewhere. That is the position the US Federal Reserve has taken, no matter that inflation is the result of supply shocks and not demand-driven. The Fed couldn’t care less what happens to the rest of the world.

The reasoning is as follows. If high levels of inflation persist, these get entrenched in household and firm behaviour and expectations. Workers demand more wages if they think inflation will persist. Firms pass on the price increase to customers. A wage-price spiral results.

It behoves the central bank, therefore, to quash expectations. The best way to do so is to raise interest rates aggressively instead of in small doses. The latter will only prolong the period of high inflation and result in higher costs to the economy. That is said to be the great lesson of the Paul Volcker tightening of the early 1980s after the stagflation of the 1970s.

The UNCTAD report points out that the inflation we face today is quite different from that of the 1970s. Hence, aggressive tightening is not the answer.
 

First, the recent increase in commodity prices, in real terms, is smaller than in the 1970s and the energy-intensity of GDP itself has declined, so a less heavy hand is needed to deal with inflation.

Secondly, global inflation is driven by fewer sectors than in the earlier episode. Core inflation (inflation excluding food and energy prices) today is much lower than headline inflation; in 1979-80, the two were almost identical.

Thirdly, and most importantly, nominal wage increases are not keeping pace with consumer price increases, so real wages have declined everywhere. The report ascribes this to the fact that unions have declined in importance and workers today have less bargaining power. This casts serious doubt over the existence of a wage-price spiral.

Fourthly, shadow banks have grown in importance as providers of credit (yes, even after the global financial crisis of 2007). This greatly complicates the transmission of monetary policy. Greater central bank independence and inflation targeting do not necessarily translate into greater effectiveness of monetary policy.

Illustration: Binay Sinha

 

UNCTAD’s scepticism about a wage-price spiral is shared by the International Monetary Fund (IMF) in its recent World Economic Outlook (October 2022). The IMF, like UNCTAD, notes that real wages today are falling. It looks at 22 situations in the past 50 years when price inflation was rising but real wages were falling and the unemployment rate was flat or falling. In these episodes, there was no wage-price spiral. Instead, inflation came down in subsequent quarters. Unlike UNCTAD, the IMF will not allow its findings to influence its prescription. It still roots solidly for tightening of monetary and fiscal policy.

You may ask: What alternative to monetary tightening do we have? UNCTAD proposes radical alternatives. It suggests a mix of subsidies, price controls and intervention to check excessive speculation in commodity markets.

It wants fiscal and monetary policy to be tailored to support job creation and development projects. It also wants industrial policy to target desired sectors (production-linked incentives or PLI, anyone?) with public sector banks playing an important role. It sets its face against tax reductions and instead would like taxes on wealth and windfall profits.

Lastly, it wants a new and improved international financial architecture. The new version will provide better balance of payments and liquidity support, a swap facility for all, a public credit rating utility and rules for managing sovereign debt crises.

There isn’t much hope that the alternatives to aggressive tightening that UNCTAD proposes will find takers in the corridors of power in the Western world. The least that central banks in advanced economies could do is to heed the recent warning of a World Bank study about simultaneous tightening by central banks. 

The study warns that such tightening would be “mutually compounding” and result in a recession greater than is necessary to control inflation. If central banks coordinated their monetary policy responses, they could hope to rein in inflation without sacrificing too much growth.

Alas, such coordination is missing today, unlike in the global financial crisis or during the pandemic. As India gets ready to assume the presidency of the G20 in December, it should take the lead in pressing for greater global coordination of policy responses to the present challenges.

ttrammohan28@gmail.com