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IN many countries the goal of monetary policy is to ensure that inflation is neither too high nor too low.
It became fashionable during the 1990s to set a country’s Central Bank an explicit rate of inflation to target. By 1998, some 54 Central Banks had an inflation target, compared with just eight at the end of 1990, the year in which New Zealand’s Reserve Bank became the first to be set a target.
In most industrialised countries, the target, or, typically, the mid-point of a target range, for consumer-price inflation is between one per cent and 2.5 per cent.
The reason it is not zero is that official price indices overstate inflation, and that the countries would prefer a little inflation to any deflation.
According to the IMF, inflation in oil-exporting countries has increased to over 7 per cent, owing to increased domestic demand pressures and, in some countries, the depreciation of the dollar (to which their currencies are pegged) against currencies of major trading partners.
Increases in inflation have been lower in countries with very open product and factor markets, such as Kuwait and Saudi Arabia.
The IMF feels inflation is rising fuelled by rapid demand growth and strong foreign inflows. With monetary policy largely accommodative in many countries, inflation is expected to average nearly 9 per cent in 2007 compared with 7.5 per cent last year.
The uptick is particularly notable in the GCC where higher inflation is beginning to translate into more appreciated real exchange rates, as would be expected in response to increased oil prices.
To make matters worse, oil export revenues are projected to decline slightly to $570 billion in 2007 based on an average oil price of $61 a barrel, down from $64 last year. Naturally, the revenue projections are highly sensitive to oil prices, with a $5 a barrel decline estimated to reduce the region’s annual exports by $45 billion and fiscal receipts by $35 billion.
Experts hold that continued spike in rents, increased commodities prices and demand pull pressures would jack up the CPI (consumer price index) even as surging oil prices may aggravate the situation even further. While the Bahrain economy would be in peril if oil falls below $40 a barrel, there are also dangers if it stays high.
The six GCC states should co-ordinate their public expenditure policies to reduce inflation pressures, Bahrain Central Bank governor Rasheed Al Maraj says adding, “we need to co-operate and co-ordinate on public expenditure which has led to an increase in local demand.”
Bahrain Economic Society member Mohammed Habib Ali believes the country is currently experiencing a period of high inflation and warns that action must be taken to ward off the critical state of hyperinflation. “Unfortunately, the majority of our monetary policy tools are in the hands of the American Federal Reserve, therefore our central bank is very much tied,” says Ali.
He notes that inflation is turning ugly, prices are rising and incomes are not keeping up with the rise. Even the 15 per cent pay rise granted to government workers in Bahrain would only benefit some 34,000 workers in the public sector. The unions had demanded an increase in the salaries of the lowest paid workers in the government based on a cost of living index.
Be that as it may, the flipside of the issue is that more spending power means that money supply could grow unbridled paving the way for double-digit inflation.
The natural corollary to that is overpriced assets whether property or stocks.
The construction and real estate sector has had a very good run. But how long can the asset appreciate before property is no longer perceived to be good value?
Leading bankers warn that at a macro level, the squeeze on personal disposable incomes is likely to compel individuals to utilise savings, borrow or delay repayments on existing borrowings.
The danger for the Bahrain economy over the next year is whether local investors will start to factor in lower returns for their investments. It is clear property prices will either decline in value or at the very least slow in appreciation.
Research suggests that if central banks focus on inflation, they do a better job at controlling inflation.
But controlling inflation is not an end in itself: it is merely a means of achieving faster, more stable growth, with lower unemployment, argues Joseph E Stiglitz, Nobel Laureate and economist.
Most governments of the Middle East have opted for securing a fixed exchange rate of one sort or another, despite the costs, but none has shown signs of an impending catastrophe with the current account.
That said the cost of building and holding foreign-exchange reserves is an opportunity cost that must be weighed against the potential risk of currency devaluation and capital flight.
The reason for maintaining a fixed exchange rate, or one that trades within an exchange-rate band, is to keep a lid on inflation.
Given that easy monetary policy causes inflation and subsequently erodes the value of the currency, a country that commits itself to a fixed exchange rate against the US dollar, for instance, thereby commits itself to the same inflation as the United States.
Talking Business with
By K S Sreekumar
sreekumar@tradearabia.net
