Inflation should be viewed as public enemy number 1: here’s why

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Jannie Rossouw

Visiting Professor at the Business School, University of the Witwatersrand

Inflation is a process of sustained increases in the general price level over a period of time, typically 12 months. Inflation can be calculated for a country, for specific regions in a country and for different income and demographic groups, for instance pensioners.

These different calculations are important because the spending patterns of regions and groups differ. That means that their rates of inflation also differ. It is therefore important for each household to have a clear understanding of its own inflation rate. A number of countries allow for the development of this improved understanding. For example, South African households can use an Internet tool such as the personal inflation calculator of Statistics SA . A personal inflation calculator, based on the spending patterns of household, is also available for the Euro area, Canada and New Zealand.

The phrase describing inflation as ‘enemy number one’ is borrowed from the research done by South African businessman Dr Anton Rupert on the world-wide inflation problem suffered in the 1970s.

GLOBAL BUSINESS DIGEST & MARKET ANALYSIS PAN Finance Magazine Q2 2022

He described inflation this way due to its distortive impact on the economies of countries and the wealth and financial well-being of households.

But the word inflation has a much earlier origin. Its first use was in the US between 1830 and 1860, when the US dollar started losing value.

In short, people experience inflation as sustained price increases. Prices continue to increase and the same amount of money buys less goods and services over time.

WHY IS IT SO BAD?

Inflation is bad because people on fixed incomes such as pensioners get poorer over time. The buying power of their money is eroded.

A further problem is that borrowers enjoy an advantage over savers. With high inflation, the capital value of savings is eroded, while the real burden of borrowing declines. It becomes easier to repay debt. Although interest rates increase with higher inflation, the real value of the amount borrowed that has to be repaid, declines as percentage of salaries that are adjusted for inflation. Governments are the largest borrowers in the world. They are therefore the major beneficiaries of inflation, as the real value of their debt is eroded at the expense of the taxpayers in their countries. Tax collections increase with higher inflation and government debt becomes a smaller percentage of government revenue raised from taxes.

WHO MANAGES INFLATION AND WHAT INSTRUMENTS CAN THEY USE?

Central banks have responsibility for containing inflation. They use the level of interest rates to contain inflation.

This responsibility for containing inflation is most noticeable in countries that use inflation targeting. In these countries, central banks adjust interest rates in line with the rate of inflation and its expected future level to contain it to the target range.

To contain inflation, central banks must keep interest rates above the inflation. This difference between the rate of inflation and the interest rate is called the real rate). When the rate of inflation accelerates and is expected to continue this trend, the central bank’s policy response is a higher interest rate level (both nominal and real), commensurate with the change in the inflation trajectory.

WHAT CAN GO WRONG?

Central banks can make wrong assumptions and use wrong projections in their assessment of future inflation. This can lead them to set interest rates at an inappropriate level.

An example is the recent acceleration in the inflation rate in the US to a level above 8%. At an average of around 3% per annum, the US inflation rate was at a very low level for the last four decades). Recently the rate accelerated to above 8%, without an appropriate policy response by the US Federal Reserve.

As a result, US inflation could become a persistent problem.

This unexpected acceleration in prices caught US households by surprise. Many households (for instance pensioners) who assumed that inflation would remain under control, are now faced with much higher expenses without a commensurate increase in income.

It is therefore important that central banks are constantly vigilant and respond to accelerating inflation. Inevitably, this implies setting interest

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rates at an appropriate real level above the rate of inflation.

The real rate of interest rates can be calculated in several ways. The simplest and easiest way to calculate is by deducting the rate of inflation from the nominal interest rate.

Some African countries suffer persistent inflation problems, with rates much higher than in developed economies. The Zimbabwean inflation rate for the year to April 2022 accelerated to 96.4% , while Ghana’s inflation rate was 19.4% over the same period.

Countries suffering high inflation experience exchange rate pressure, with declining currency values. The exchange rate of the currency will remain under downward pressure as long as high inflation persists. Owing to high inflation, investment in the country becomes unattractive. The demand for the currency therefore declines, which puts the exchange rate of the country with high inflation under pressure.

The Ghanaian currency has already depreciated by 18% against the US dollar this year. A further value decline is expected for the rest of this year.

Over the past year, the Zimbabwean RTGS dollar has lost more than half its value against the US dollar).

Owing to sharp currency depreciation, the domestic prices of imported goods and services in countries like Ghana and Zimbabwe have increased sharply and continue to increase each time the currency depreciates.

Consumers in those countries who earn income in local currency experience increasing difficulty to afford imported goods and services.

THE TRUST DEFICIT

A problem in an environment of sustained inflation is that people do not trust the official published rate of inflation. Inflation rates are distrusted for several reasons. The first is a general distrust of government conduct. This results in a view that inflation rates are manipulated by government agencies responsible for their publication to report lower price increases than is actually the case.

Secondly, increased prices for goods such as fuel that receive considerable publicity, lead to perceptions of general price increases. This problem is linked to the fact that price increases are much more visible to consumers and attract more attention than price declines.

Lastly, inflation measures price increases on a cumulative basis, using each previous year’s price level as the base for calculations. This implies that each previous year’s inflated price level is used to measure the rate of inflation in the next year. Over time the cumulative effect of sustained inflation becomes quite large.

This can be explained in a different way. With a sustained inflation rate constant at 5% per annum, the intuitive perception is that prices will double every 20 years. In practice, however, under these conditions, prices will double every 14.4 years. Price increases therefore exceed the perceptions of consumers.

Given the negative impact of inflation, it is in the interest of all consumers that the authorities should always apply policies that prevent price increases or keep such increases to a minimum level.

Inflation does not make people wealthy, despite the fact the governments and borrowers enjoy benefits from inflation. Which is why the description that inflation is public enemy number 1 is so accurate.

GLOBAL BUSINESS DIGEST & MARKET ANALYSIS PAN Finance Magazine Q2 2022

Jim O’Neill

A former chairman of Goldman Sachs Asset Management and a former UK treasury minister, is a member of the Pan-European Commission on Health and Sustainable Development.

Another Global Recession?

Between falling real incomes in advanced economies, China’s weakening outlook, and the uncertainties stemming from Russia’s war in Ukraine, there is more than enough reason to worry that the post-pandemic recovery is giving way to a downturn. But there is still much that policymakers could do to mitigate the blow.

At the start of the year, I expressed concerns about the outlook for financial markets, owing to all the considerable uncertainties that I could identify, and to the many other potential risks that were not yet clear. This was after Russia had begun to mass troops on Ukraine’s border, but before it had invaded. Now that Russia has launched its war of aggression, it has been almost totally removed from the international economy and markets, and energy and food prices have spiked.

At the same time, Western central banks have undertaken a major shift in their policy stances, having finally dropped the idea that today’s inflation is a merely temporary phenomenon that would subside on its own. They are now deliberately tightening global financial conditions (by both unwinding their balance sheets and increasing interest rates), and this is adding to cyclical pressures on household incomes, and thus on the wider economy.

As if that weren’t enough, China’s economy – the world’s second-largest and ten times bigger than Russia’s – has been deliberately held back by the government’s “zero-COVID” strategy. And this comes on top of existing efforts to dampen excessive housing prices, reduce credit growth, and rein in business sectors (starting with major tech conglomerates) that are seen to be interfering with the government’s new “fairer growth” objective.

Given these developments, it looks as though a global recession could be upon us. If so, it will have been remarkably sudden, coming so soon after the lockdown-induced mini-recessions of 2020 and 2021. How bad will this downturn be, and are there policies that could avert it, or at least minimize its scale and severity?

In China, policymakers are worried that a more relaxed stance on COVID-19 could drive up infections and overwhelm the country’s urban hospitals. Since we have already seen the same sequence play out elsewhere – particularly in the United Kingdom, which was forced to impose sudden, harsh lockdowns in 202021 – China can hardly be criticized for being generally cautious. But the evidence suggests that Omicron (the dominant global variant) is so transmissible that even lockdowns are unlikely to stop it completely. Moreover, it appears to be less virulent than previous variants, which makes a draconian response harder to justify.

China’s blunt zero-COVID strategy comes on top of an already weak economy, so it has added to underlying cyclical weaknesses. The most recent trade data (for April) show that Chinese imports remain exceptionally low – just one of many signals pointing to a weak economy.

The problems facing China have implications extending beyond the economy and markets. China’s single-party leadership has long legitimized its rule by delivering ever-rising living standards for the country’s 1.4 billion people. But this implicit pact cannot easily be sustained under conditions of persistent economic weakness.

Having watched China for more than 30 years,

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I would say that one of its government’s biggest strengths has been its exceptionally good risk management. In the past, it has dealt with major potential problems decisively and in a timely manner. Not so today. If it doesn’t change course soon, there will be much more pain in store for its economy and for the rest of the world. On the other hand, if the government can abandon “zero-COVID” and some of its other more draconian economic crackdowns, growth could well rebound quickly.

As for the rest of the world, two major factors beyond China will determine how things play out: major central-bank policies and Vladimir Putin. The Russian president’s intentions remain as difficult to predict today as they were three months ago when he launched his invasion. Finland and Sweden’s sudden support for joining NATO shows that Putin has miscalculated abysmally. Though he might not end the war, his stupidity may well result in his removal from power (though many Kremlinologists consider this unlikely).

In any case, the blow to real incomes – and thus to consumer spending – from higher energy and food prices has been so large that central banks ought to think twice about their newfound hawkishness. After all, if the way to bring inflation under control is to weaken the economy, surging energy and food prices, together with tightening financial conditions, might have already done central banks’ job for them.

To be sure, if longer-term inflation expectations are rising and no longer anchored, that would change the calculation considerably. In the United States, where the Federal Reserve’s policy changes have far-reaching global effects, the latest Consumer Price Index shows core inflation still above 6%, with service-sector price inflation accelerating. As such, the Fed might see little reason to abandon the tightening path that it has so loudly hinted at.

But the Fed would do well to consider the reduction in real (inflation-adjusted) disposable incomes in the US. Though the decline hasn’t been as severe as in Europe, it has been significant, and the strong tightening of financial conditions may have already sown the seeds for an economic downturn soon.

So, are we heading into a global recession? Much will depend on the Fed, the Chinese leadership, and the erratic, isolated cipher in the Kremlin.

GLOBAL BUSINESS DIGEST & MARKET ANALYSIS PAN Finance Magazine Q2 2022

J. David Stewart

a former managing director at JPMorgan, is a sustainablefinance consultant.

Henry P. Huntington

an Arctic researcher and conservationist.

How Big Finance Can Scale Up Sustainability

The disconnect between those developing sustainability projects and the world of traditional finance means that scaling such initiatives is not straightforward. Three steps in particular are necessary to help mobilize the trillions of dollars needed to address the ever-worsening climate crisis.

EAGLE RIVER, ALASKA – Addressing the ever-worsening climate crisis will require the largest sustained movement of capital in history. At least $100 trillion must be invested over the next 20-30 years to shift to a low-carbon economy, and $3-4 trillion of additional annual investment is needed to achieve the Sustainable Development Goals by 2030 and stabilize the world’s oceans.

Mobilizing these huge sums and investing them efficiently is well within the capacity of the global economy and existing financial markets, but it will require fundamental changes to how these markets work. In particular, traditional financial institutions will need help in sourcing the right projects, simplifying the design and negotiation of transactions, and raising the capital to fund them.

Many sustainability ideas are small-scale, which partly reflects the nature of innovation, whereby ideas are developed, tested, and, if successful, eventually copied. But the disconnect between those developing sustainability projects and the world of traditional finance means that scaling such initiatives is not straightforward.

At the risk of oversimplifying, sustainability advocates may be suspicious of “Big Finance” and its history of funding unsustainable industries. Investors, on the other hand, may be wary of idealistic approaches that ignore bottom-line realities, and might not be interested in small-scale transactions.

Given this disconnect, how do we scale up sustainable projects from small investments to the $100 million-plus range that begins to attract Big Finance and thus the trillions of dollars needed to make a global difference?

Three steps in particular are necessary. First, securitization techniques should be employed to aggregate many smaller projects into one that has enough critical mass to be relevant. Securitization got a bad name in 2007-08 for its role in fueling the subprime mortgage crisis that brought the developed world to the brink of financial ruin. But when properly managed, joint financing of many projects reduces risk, because the likelihood that all will have similar financial and operational issues simultaneously is low. For the resulting whole to interest investors, however, the numerous smaller projects need to have common characteristics so that they can be aggregated. This cannot be done after the fact.

For example, we need to develop common terms and conditions for pools of similar assets, as is already happening in the US residential solar market. Then, we need to explain the fundamentals of securitization to more potential grassroots innovators through regional conferences that bring together financiers and sustainable-project developers.

Second, we must reduce the complexity of key transaction terms and make it easier to design and negotiate the specifics of instruments used to invest in sustainable projects. In established financial markets, replicating significant parts of previous successful deals is much easier than starting from scratch for each transaction. This approach works because many of the terms and conditions for subsequent deals have already been accepted by key financial players.