Honey I blew up the Inflation 

   “The war in Ukraine, lockdowns in China, supply-chain disruptions, and the risk of stagflation are hammering growth. For many countries, recession will be hard to avoid,” said World Bank President David Malpass.

 

Honey I blew up the Inflation 

The recent surge in global inflation is reminiscent of the Hollywood sci-fi hit Honey I blew up the Kids. Putting aside the pun, those were the good old days of cinema when creativity blended well with storytelling. The proliferation of technology and media brought the world out the delusion that the world is a safe place where good wins over evil. Hence the rise of Superhero’s in movies heightened the imagination of alpha humans fighting for a better world. However, the recent rise in global inflation is less delusional with tell-tale signs of its making spread out over the last few years. As we read further, we look at emergence of Stagflation – the Clear and Present Danger facing the world today.

Globally inflation has shot through the roof on the back of weak economic growth. World Bank has sounded the alarm that global growth is coming down to 2.9 percent this year down from 5.7 percent last year  High inflation erodes the purchasing power of consumers and one of the most potent weapons in disrupting economies. The impact of inflation is most significant for the less privileged section of the society. The inflation in Euro area rose to 7.4 percent in March 2022 compared to the 5.9 percent in February 2022. Housing, electricity, gas etc and transport showed the highest increase respectively. The euro area inflation on the back of fuel reset due to the Russian invasion of Ukraine. COVID-19 had already disrupted the supply chain of commodities before the onslaught of the Russian invasion causing irreparable humanitarian crisis and damage to the fragile global economy. The lockdowns in China further exacerbated the problem. Apart from the tragic humanitarian crisis, the Russian invasion amplified food prices, especially wheat, where Ukraine and Russia dominate world exports. The inequitable vaccination distribution and the emergence of new mutations of COVID-19 constantly torment the increase in COVID-19 infections worldwide.  Today the world faces twin threats of high inflation and low growth, a phenomenon termed Stagflation in economics.

Ayhan Rose of the World Bank describes Stagflation as a toxic mix of weak growth and high inflation, a problem confronting economists. 

Loose monetary policy by central banks with a limited boost to the supply side of the economy has led the world to its predicament today. As interest rates increase globally across major economies with notable exceptions there is a growing global consensus on the direction of interest rates. and the rising threat of inflation and growth imbalance. Stagflation is not a new phenomenon, the US went through Stagflation in the 1970s, thanks to Paul Volcker’s single-minded focus on attacking inflation helped to temper the rate of inflation.

Read the publication on economics governing the pandemic here.

Looking at the unprecedented era of low-interest rates, the increase in policy rates was long due. The move to increase the rates is judicious as high inflation reduces the purchasing power of households, increases the cost of capital for corporates, and makes living more difficult, especially for the less privileged section of the society. It’s important to understand the difference between nominal and real interest rates.

Note Nominal Interest Rates = Real Interest rates + Expected Inflation, a simplification of the Fisher equation. Buying assets not only boosts liquidity within the system but also increases inflation. Nominal Interest Rates are interest rates banks charge on deposits or financial returns on bonds. Nominal interest rates include price effect and are considered the opportunity cost of capital. Real Interest Rates define the purchasing power of households and are adjusted for expected inflation. For the above equation, ex-ante real interest rates are when we use expected inflation, it becomes post ante when actual inflation is substituted for expected inflation.

Social Change & Impact

The FED is the most significant central bank in the world and its actions impact global capital flow. A prolonged accommodative policy leads to asset bubbles and a socio-economic crisis. Asset bubbles inflate prices of assets above their intrinsic value, leading to wealth effects for the privileged section of the society, thereby rising inequalities within societies. Timely corrective measures lead to better-sustained well-being over time. Leaving interest rates low encourages unwanted risk taking, boosting unsustainable growth and encouraging debt drive lifestyle by households. Delay in corrective measures by central banks could lead to deep recessions that have large social costs attached i.e. longer periods of contraction, prolonged higher unemployment rate, less spending on research & development, higher socio-economic disruption. Prolonged periods of recession or depression lessens budgetary allotment to development projects in low- and middle-income countries. First, lets understand demand and supply shocks to an economy.

 

 

Video: Shocks to an economy | The middle Road 

Phillips Curve

A W Phillips published a landmark paper on the inverse causality between between unemployment and inflation in the paper “The relation between unemployment rate and the rate of change of money wage rates in the United Kingdom, 1861 to 1957”.  The wage growth extended to inflation as a (growth in wages leads to rise in aggregate demand leading to rise in inflation). FED has a dual mandate of price stability and maximum employment will face a tough task ahead. The Phillips Curve worked as a policy tool for the central banks in balancing inflation and unemployment rate in the past is no longer a valid option. The curve has been flat forcing economists to look for other measures of balancing act.

James Bullard President and CEO of the Federal Reserve Bank of St. Louis in his landmark presentation Three Themes for Monetary Policy in 2019 pointed out that Philips curve does not hold for the last two decades.

Philips Curve until some time back was a guiding light for understanding the correlation between labour market and inflation. An insightful learning from the research is important.

“The US labor market is performing well, but feedback from labor markets to Inflation is very weak.”

The FED measures inflation using personal consumption expenditures (PCE) inflation, subtracts 30 basis points from the widely popular market-based index. To know more about various types of inflation, refer to the Understanding Macroeconomics online course published on The middle Road. Despite high employment within the US economy along with asset purchases, FOMC missed its PCE inflation on annual basis since 2012.

Refer to the unemployment rate of the US below.

US Unemployment Rate

2001 -2022    Average: 6%, Median: 5.5%

2001 – 2010  Average: 6.1%, Median: 5.6%

2011- 2022    Average: 6%, Median: 5.4%

The weak correlation between unemployment rate and inflation has been propounded before. Economist Mishkin in his text book Macroeconomics Policy & Practice also articulated the weak correlation between employment and inflation rate. The middle Road did some very basic data analysis. Using unemployment rate in percent and consumer price index (percent change from a year ago monthly data for the US from Jan 2000 till March 2022. The CPI adjusted by subtracting 30 bps to find the correlation for the two data points. The correlation would be same even if adjustment did not take place.

Correlation between = – 0.362 (Jan 2000 till March 2022)

The inverse correlation has fallen further more in the last decade.

Correlation= -0. 152 (Jan 2011 till March 2022)

Global Stagflation

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The situation is more worrisome for emerging and low-income countries that have debt marked by foreign borrowings. As rates go up, the borrowing rates will go up making it difficult for various entities including sovereigns to service their debt. High interest rates increase the cost of funding, reduce household consumption power as cost of living increases. A global slowdown, reduces capital allocation towards the research and development impeding technological innovation. Keeping other factors of production constant, a reduction in research and development expenses would reduce the level of global output in the long run. In the long run, shifts in Aggregate Demand impact price level but not output and employment.

The output i.e. aggregate supply is vertical with output determined by amount of capital, labor, the level of technology, data. The middle Road recommends equitable education as one of the factor enablers. Further, according to the World Bank, if the per capita growth is going to be less for most of the emerging countries compared to that of advanced countries, the economic inequality is going to widen between emerging and advanced economies as we advance. The pandemic has already widen both economic and education divide among countries. Based on the World Bank research, the pandemic will push an additional 72 million primary school-aged children into learning poverty, i.e., they will not be able to read and understand a simple text by age 10.

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As countries battle the onset of stagflation, The middle Road foresees that countries like the US that have dual mandates will more likely abandon dual mandate to focus primarily on price stability at least for the next few years.

Introducing export bans, food and fuel subsidies and price controls are few policy initiatives decried by the World Bank. To rise above the challenges ahead, the world needs to work together, be scientific and evidence oriented and set up frameworks that enable social change and impact for global harmony. Subscribe to the upcoming subscription plan on The middle Road to access all content including many online courses.

 

 

 
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