Inflation could prove more persistent

Overall inflation has been moderating over the last few months in the US, EU and other advanced economies. These economies, in particular the US economy is likely to avoid a recession. In fact, for the last three decades it was relatively easy for central banks in advanced economies to keep the rate of inflation low and stable.
But monetary policy tightening cycle started in these countries when inflation was already elevated. Monetary policy always operates with a considerable time lag, and the pace and time always remain uncertain of its impact. Now delayed monetary policy response to inflation and the structural changes brought about by the changing US trade policy, the pandemic and the Russia-Ukraine conflict have made the inflation fight even more difficult and uncertain.
Year on year headline inflation is now around 3 per cent in the US and below 5.5 per cent in the Euro area. But core inflation which excludes food and energy prices has declined more slowly, services inflation has remained sticky. The IMF in its updated World Economic Outlook expressed the view "Inflation could remain high and even rise if further shocks occur, including those from intensification of the war in Ukraine and extreme weather-related events, triggering more restrictive monetary policy".
While monetary policy is tight, its impact is significantly moderated by countervailing expansionary fiscal policy measures, e.g., the US budget deficit is currently running at 5 per cent of GDP. Such a high level of budget deficit is usually the case during recessions and wars.
The US economy also faces a very unusual situation where a combination of lowering inflation and a very tight labour market exist now. Such a situation negates the long-held view by economists that there is an inverse relationship between inflation and unemployment. This in economics is known as the Phillips curve. The inverse relationship between unemployment and inflation is depicted as a downward sloping, concave curve, with inflation on the Y-axis and unemployment on the X-axis. Increasing inflation decrease unemployment and vice versa. Alternatively, a focus on decreasing unemployment also increases inflation, and vice versa.
It is now widely believed that inflation possibly proves to be more persistent than anticipated because inflation expectations continue to shift upward as the corporate profit share in price rises continues to rise (hence pushing prices up) triggering higher wage demands to compensate for decline in real wages. Research conducted by the OECD as part of its "2023 Economic Outlook" has confirmed that inflation has mostly been driven by corporate profits since 2019.
In the US, headline inflation ticked up to 3.2 per cent in July up from 3 per cent in June according to the Bureau of Labour Statistics. But underlying inflation which excludes food and energy and possibly other volatile items appears to be decelerating in the US. Core inflation (sometimes referred to as underlying inflation) in the Eurozone, the key measure of price gains for the European Central Bank (ECB) accelerated in June. Core consumer prices rose 5.5 per cent from a year earlier compared to 5.3 per cent in August according to the Eurostat.
As inflation continues to be stubbornly sticky in the US and the Eurozone, economists are widely anticipating further rate hikes by the US Federal Reserve (the Fed) and the ECB. Since the 1980s central banks pursued their commitment to targets but have failed to anticipate the persistence of inflation over the last two years. Also, by rate hikes, central banks expect to contain inflation expectations to drift upward. Now by resorting to interest rate hikes to bring inflation to the target rate i.e., 2 per cent, they will induce a recession rather than a disinflation.
It is estimated that the unemployment rate would have to go up to 6.5 per cent in the US to bring inflation down to the target. Former US Treasury Secretary Larry Summers called for five years at 6 per cent unemployment or a year at 10 per cent unemployment in order to bring down inflation to the target rate. But that may not work out as expected.
Central banks always used interest rates to manage demand for goods and services through the cyclical variations from expansion through to peak, contraction through to trough then to recovery. In summary, the business cycle represents economic growth and decline through distinct phases. So, it was not all that a difficult job and central banks always congratulated themselves on their success.
But central banks' job was made easier because of the structural changes to the global economy brought about by growing globalisation which reduced barriers to trade and foreign investment, increased flows of trade and money between the developed and developing economies contributing to the huge increases in global output causing downward pressures on prices of goods and services around the world. Globalisation has made it easy to keep inflation low. The process of globalisation which helped so much to keep inflation low, is now reversing.
It is a widely shared view that many factors are at work now that will cause disruptions in the economy leading to price rises making it difficult for central banks to bring inflation down to the target level. The surge in prices over the last two years or so came from disruption caused by the pandemic and the Ukraine conflict.
While such disruptions to the supply side of the economy are unusual, they seem to be in the process of becoming more normal as one also considers the more inward-looking trade policy of the US, in particular the US' rivalry with China and widespread use of trade sanctions. In fact, economies are now more accustomed to higher living costs as businesses charge higher prices to consumers as reflected in very high share of profits in rising prices.
According to the Office of the US Trade Representative, the US is the second largest trading nation, behind only Chia, with over US$7.0 trillion in exports and imports of goods and services in 2022. The US has trade relations with more than 200 countries, territories and regional associations around the globe. This statement clearly indicates the importance the US in the global economy and the global trading system. Therefore, US trade policy plays the most significant role in influencing global flows of goods and services notwithstanding the issues relating to climate change, in particular extreme weather events disrupting agricultural production and the ageing of population in advanced economies.
While inflation is a significant global problem, its impact on developing economies like Bangladesh is very harmful. Rising food prices lead to more food insecurity and declining real income is pushing more people below the poverty line. It is estimated that 40 per cent of consumer budget is accounted for food alone in most developing countries.
Stubbornly high inflation not only in developed countries but also in developing countries has prompted the most aggressive interest rate hike cycle in decades, causing financial conditions to tighten and exacerbating debt vulnerabilities. As the Fed kept raising interest rates to fight inflation, that in turn made inflation problem to further worsen in developing countries by a surging US dollar as most these countries borrow in the US dollar.
Also, the downgrading of the long-term credit-rating of the US by the Fitch Rating Agency on August 1 further added to the current global economic turmoil and uncertainty. The downgrade reflects the massive surge of the US federal government debt and the recent turmoil in the banking sector. The August 1 credit downgrade also foreshadows higher rates driving up debt service costs. The US has been able to borrow suchever-greater record levels of money because of the dollar's role in the global economy.
The US credit downgrade has major economic ramifications for developing countries, particularly in terms of the cost of borrowing and depreciation of the currency. A depreciating currency is expected to create inflation by driving up the price of imported goods and services-triggering what economists call exchange rate pass-through.
The Australian Financial Review warned that the US credit downgrade is a "wake up call to other nations in fiscal mess". This is a description that can be applied to governments around the world whose debts have risen to record levels.
Now it is clear that supply side will continue to exert pressure on prices causing supply shocks. So, to keep inflation in the target range is likely to be a very difficult task. Therefore, central banks are now in a very difficult situation where they are likely to steer a course between high inflation and recession.
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