CHRIS LOEWALD: Why inflation is public enemy No 1

While the 2008 global financial crisis (GFC) caused deflation, the pandemic’s shifting consumption patterns, supply limitations and expansionary policies have generated the opposite. 

Monetary policy has tightened in response, prompting critics to warn of political backlash. They suggest that the policy is wrong, and question the value of independent central banks in the light of fiscal needs. Given today’s high inflation, it’s worth taking a longer view of macroeconomic policy co-ordination since the GFC. 

The GFC and the pandemic certainly gave rise to extraordinary, lingering policy responses. These featured very low interest rates and the aggressive buying of debt and equities. Central bank balance sheets increased dramatically to take loss-making assets off the accounts of financial institutions. This further cut borrowing costs for sovereigns looking to finance larger deficits and higher debt levels.

Unfortunately, these efforts have had self-fulfilling elements. Responding to every negative economic shock with expansion fosters overleveraging and ever-bigger losses to absorb in the next round of crises. 

Emerging markets also failed to escape the logic of those policy efforts.  Measures implemented during the 1997 Asian financial crisis such as healthy foreign exchange reserves, more sustainable fiscal policies and transparent inflation-targeting frameworks fell by the wayside when the GFC struck.

Not surprisingly, emerging market debt levels rose quickly up to the advent of the pandemic and through it.  In South Africa’s case, the public debt level roughly tripled in 10 years. Between 2009 and 2022, the average real policy interest rate was 0.7%, well below the neutral real rate of 1.7%. 

However, an effort was also made to avoid future financial complications. Raising capital buffers for financial institutions, for example, provided offset to higher leverage. Unfortunately, such prudence did not always apply to all fiscal decisions, leaving countries without space to manoeuvre when the pandemic hit.

Still, should central banks and fiscal authorities switch direction now, away from combating inflation, out of concern for weak growth and inequality?

Certainly, the post-GFC policy effort was animated in part by the idea that any fiscal effort must increase real GDP.  But what if it primarily raised inflation?  Surprise inflation boosts nominal GDP and flatters fiscal balances in the very short term but, if sustained, higher inflation leaves the public sector with less real purchasing power and permanently higher interest costs.  

If inflation undermines economic growth and fiscal sustainability, then it is hard to see how fighting it puts monetary policy at cross-purposes with fiscal needs. Monetary policy tries to limit the pain of inflation by preventing surprise income loss from turning into continuous losses. Over the longer term, lower and more stable inflation also reduces the cost of debt.  

Allowing inflation to rise because we believe it will temporarily lower real debt costs for households is also counterproductive. A 10% rise in prices is a 10% fall in the real income of every household.  By contrast, if policy tightens by three  percentage points, the debt service cost for a household with debt of 30% of one year of income will rise by just under 1% of annual income.

The worst affected are more marginalised households and small businesses.  When prices spiral, the highest economic cost falls on those most likely to lose jobs or suffer long-term income loss. The incomes of poorer households depend more on grants and fixed pensions; they consume in larger proportion the kinds of things hit harder by rising prices (such as food, energy, housing and transport).  In many countries, poorer households borrow little whereas richer households borrow more, at lower interest rates.

In prolonged stagflation, which is high inflation combined with high unemployment, the longer-term economic costs — to cost of production, investment and jobs — are increased, making it important to end the situation as soon as possible. In doing so, we should endeavour to avoid recession, in part through careful calibration of interest rates, but it’s important to recognise that real income levels over time are not much related to temporary dips in economic activity. 

Instead, legitimately unpopular wage stagnation and inequality are features of weak productivity growth and higher inflation, in particular thanks to asset prices turbocharged by expansionary monetary and fiscal policies.

Wage stagnation is also more likely due to our failure to reap the productivity gains of globalisation. In South Africa's case, commodity prices were the primary channel for the benefits of globalisation, and could have contributed to more efficient public spending on education, transport, housing and the like. The solutions to stagnant wages and weak job growth include becoming more productive, allowing more competition and nurturing people’s ability to engage in economic activity by lowering the cost of doing so.

In the absence of stronger productivity growth, further policy expansion simply creates more asset price inflation. If we assume societies learn from the limitations of monetary policy that is too expansionary, our current malaise should turn populations against high inflation, rather than question the present actions of central banks.  

Loewald is the head of economic research at the South African Reserve Bank