By Firdaos Rosli
Let me get this straight: inflation will likely come down in 2023. Inflation is already moderating in the United States (US), United Kingdom (UK), European Union (EU) and Malaysia. So, cheer up because the trend will likely persist in the coming months.
The elevated energy costs amid the Russia-Ukraine military conflict and the uneven effects of economic reopening globally are the main causes of raging inflation in 2022. The latter may be a thing of the past in 2023, but unlikely the former.
As there is no end in sight to the said military conflict, energy prices will likely remain elevated in 2023, thus making central bankers continue walking on eggshells in taming inflation. It gets more complex when China’s economic reopening will eventually push energy demand higher in the coming year.
Taming inflation is far from over. Albeit lower inflation in 2023, the topic will remain contentious for two reasons. One, despite moderating the Consumer Price Index (CPI) on a year-on-year basis, the index itself (i.e. the price level) will trend higher.
And two, owing to the Fed’s aggressive stance in reining inflation, the CPI and the Personal Consumption Expenditure (PCE) index are plateauing but still trending well above their target rate of 2 per cent. The same scenario is in the UK and EU as well.
As a result, the policy rates of these major central banks will trend higher for longer. The scenario will put much pressure on emerging currencies, ergo, imported inflation. Malaysia’s Overnight Policy Rate (OPR) will probably rise closer to its pre-pandemic levels in 2023 amid the widening policy rate and yield gaps.
Global economy, soft landing
This author's key assumption is that the global economy will find a soft landing, cowering away from global event risk.
Now, the problem does not stop here. Policymakers are accustomed to assessing inflation from the price level and surveys. Economists believe that inflation counteracts unemployment and correlates with policy rates. In simple terms, when inflation is high, unemployment is low, and the policy rate tends to increase. The reverse relationship also holds, hence, demand-pull and cost-push as the two common types of inflation.
The recent global inflation is a combination of the two phenomena. Demand-pull happens amid rapid post-pandemic labour market recovery, whereas cost-push results from high energy prices, which took place almost overnight due to the military conflict. The unfavourable foreign exchange terms amid the US dollar strengthening make it worse for all but the US, and to a certain extent, Hong Kong and Singapore. All eyes are on central banks to intervene whenever inflation becomes a national issue.
We often overlook the role of fiscal policy in taming inflation, if any. One reason is that fiscal policy appears to be more “restrictive” than monetary policy, more so when governments are out of ammunition to counterbalance the deleterious effects of the pandemic.
Another reason is that, unlike the interest rate, policymaking is extremely complex when assessing the wages/incomes’ perspective as it differs from one economic centre to another.
Lowering taxes is problematic as tax foregone could attract more problems when the labour market is tight and may even affect the core functions of the government as revenues fall. On the contrary, raising taxes to stifle demand growth is inopportune, so we can safely discard that.
The natural thing to do is to expect monetary policy to tame inflation via demand-side intervention.
Why don’t governments push for price controls and/or higher subsidies to tame inflation, you may ask? Well, it is frowned upon even if fiscal space permits them so. It is fiscally imprudent as energy prices are notoriously volatile versus other commodities. Governments may also be seen as producer-biased with the help of subsidies, which can be politically costly.
In reining inflation, some governments view being offensive as a “politically correct” thing to do rather than defensive in the event of a supply shock.
The situation differs for most net energy exporting nations, including Malaysia, that benefit from higher energy prices. Higher subsidies and tighter price controls on basic food items are expected from the get-go. These countries will be stuck in an “inflation loop” without a long-term substitute for price controls and subsidies.
The problem with pushing for a higher policy rate, subsidies and price controls is that they are still somewhat short-sighted. While demand will suffer from a high policy rate, so will investments.
We need more policy recommendations to boost investments in key inflation items, such as housing, food, transport and energy. The supply curve must shift to the right quicker than it should sans intervention so prices can be more stable over a longer time horizon. Lowering house prices is more complex as it involves varying stakeholders but not the other three main items.
The increasing application of Environmental, Social and Governance (ESG) standards helps, but it cannot be the sole channel for technological upgrading.
While governments promote a low-tariff environment to reduce price translation, behind-the-border taxes increase over time. Thus, prices remain elevated. Investments should go up as taxes come down. We rarely hear about investments in items that affect everyday goods and services we consume daily, so this scenario warrants a closer look.
Wages have also increased as inflation rises, prompting consumers to inhibit the need to upgrade their standard of living. Out-of-home food prices are primarily driven by services which are much harder to assess. Food deliveries are making lives much simpler but at the expense of higher prices due to the higher level of services rendered.
Besides, investors and business owners may not have the appetite to boost manufacturing and infrastructure investments when borrowing costs are climbing at a level unseen in decades. Let alone investments in key CPI basket items.
Although aggressive tightening may yield lower inflation in 2023, the world may again suffer from cost-push inflation amid supply shocks, and demand-pull as wages and population grow. Investments, with a view to improving productivity, in these key areas have no substitute.
Firdaos Rosli is Chief Economist at Bank Islam Malaysia Berhad.