Soaring inflation and a gloomy economic outlook – a difficult dilemma for policymakers.
Hull University Business School
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Written by Dr Gabriele Amorosi
The world economy had tried to gain some momentum and accelerate the economic recovery after a couple of years stricken by the Covid-19 pandemics and the ensuing lockdowns that have thwarted the economic performance of many economies worldwide. In its updated World Economic Outlook (WEO) of July 2021, the IMF International Monetary Fund (IMF) was depicting buoyant global economic trends for 2021 and 2022, with projected real GDP growth rates of 6% and 5.1% respectively. However, the recovery did not play out in a smooth manner, especially due to the inability of the worldwide supply chain to cope with the renewed demand for goods and services. According to Darrell M. West (2022), from the Brookings Institution, modern global supply chains are vulnerable to “… a pandemic, a war or a natural disaster”, mainly due to decades of “…outsourcing, off-shoring and insufficient investment in resilience…” of critical supplies. This started to affect the price dynamics in many economies; in an op-ed published by the Brookings Institution on June 2021, Professor Kaushik Basu, from Cornell University, referring to the rapidly increasing wholesale prices in India, stated that “…This reflects mismatches in demand and supply, which, if not corrected soon, could become a major crisis, causing macroeconomic imbalances that can affect trade and financial flows.”
On top of all the above-mentioned problems, Vladimir Putin’s invasion of Ukraine, followed by the decision of the large majority of Western countries to impose severe sanctions on Russia, has created a very perilous economic environment.?Gas supplies to Europe have reduced substantially and the wholesale gas price – also fuelled by market speculation – has consequently skyrocketed, thus boosting an already climbing inflation rate and weakening the world economy. These recent developments in the global economic and geopolitical environment have resulted in heavily deteriorating inflation expectations. According to the IMF’s WEO of April 2022, “War-induced commodity price increases and broadening price pressures have led to 2022 inflation projections of 5.7 percent in advanced economies and 8.7 percent in emerging market and developing economies—1.8 and 2.8 percentage points higher than projected last January”.
Headline inflation (Percent, year-on-year)
As shown in the above figure, inflation in advanced economies has reached levels not seen for decades. As a consequence of these adverse macroeconomic conditions, the global economy has started to slow down substantially. According to the IMF’s revised WEO of April 2022, “Global growth is projected to slow from an estimated 6.1 percent in 2021 to 3.6 percent in 2022 and 2023. This is 0.8 and 0.2 percentage points lower for 2022 and 2023 than projected in January. Beyond 2023, global growth is forecast to decline to about 3.3 percent over the medium term”.
What can policymakers do?
Following the post pandemic economic rebound, central bankers had been very cautious, until very recently, in terms of their monetary policy stance, and had refrained from raising official interest rates, in order to avoid thwarting the much-needed economic recovery. However, the main task of central banks, by statute, is the control of the price level, with inflation targets usually below (but close to) 2%. Therefore, the current prospect of mounting inflation has prompted a substantial shift in the position of monetary authorities, which have implemented a series of interest rate rises. The table below shows a recent timeline of the Bank of England policy rate.?Market speculation suggests that the rate could reach 5% in 2023.
After over a decade of accommodating monetary policy, with associated near-zero policy rates, this change in monetary policy stance has the potential to cause a lot of economic damage. Borrowing, particularly by businesses, is becoming more expensive, thereby reducing the prospect for much-needed investments. Governments too will find borrowing more expensive, which is especially bad news for countries with very large government debts. Following the current unsustainable increase in the cost of electricity and gas, for both businesses and households, most European governments have scrambled to alleviate the burden for both consumers and producers, introducing energy price caps and, increasingly, subsidies to energy bill payers. If this was a very necessary step to avoid a widespread collapse of producers and a dire winter for households in the short-term, in the long term there will surely arise questions of sustainability of such measures, especially for heavily indebted countries.
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The newly appointed British Prime Minister Liz Truss has announced her intention to freeze energy bills at the average household bill level from October 2022, a measure that, according to Reuters (Sept. 2022), could cost ￡100 billion, to be partly funded by further Government borrowing. It is worth mentioning that the UK’s public debt is already in excess of 100% of GDP, following the interventions put in place to relieve the business hit by Covid lockdowns. Italy, whose debt is in excess of 150% of GDP, has also implemented measures to partly subsidize energy bills worth dozens of billions of euros. This poses a very difficult dilemma for policymakers, who find themselves walking a thin line between the need to sustain the domestic economy and social cohesion on the one hand, and the danger of pushing public debt to a level that could be perceived as hardly sustainable on the other; this, in turn, is likely to prompt an increase in the cost of borrowing by the underlying governments, due to the higher risk premia required by investors, thus further exacerbating the public debt burden. All in all, given the current situation in Ukraine and the wider economic uncertainty pervading the global economy – several countries are already expected to enter a recession over the next few months – the task policymakers will face in the foreseeable future is not an enviable one!
References
Casselman Ben and Ana Swanson (2022), “Supply Chain Problems Will Outlast Pandemic, White House Says,” New York Times, April 15, p. B3
IMF (2022), World Economic Outlook, April 2022.
IMF (2022), World Economic Outlook, July 2022 update.