The November 15, International Monetary Fund’s (IMF’s) press release continues to see a significant role of aggregate demand in determining inflation, since it stresses upon the need to continue with a tight monetary policy– or monetary austerity– stance.
In the press release it indicates this as ‘With appropriately tight monetary policy, inflation should steadily decline and the authorities stand ready to respond resolutely if near-term price pressures reemerge, including due to second-round effects on core inflation or renewed exchange rate depreciation.’
This is strange to say the least, given both global experience in general, and Pakistan’s own experience with tight monetary policy has had little relevance for lowering inflation, which continues to remain stubborn due to strong supply-side determinacy of inflation. Global supply shock during the pandemic, and over-profiteering in the time of polycrisis– climate change crisis, ‘Pandemicene’ phenomenon, and difficult geopolitics, both on account of continuing war in Ukraine, and more recently serious heightened conflict in the Middle East – all clearly contributing strong significance to supply-sided determination of inflation.
Moreover, lack of provision of stimulus during the pandemic in developing countries like Pakistan, weak regulation allowing monopoly, and even oligopolistic market power artificially perpetuating higher profits, along with higher cost-push, and imported inflation –especially net oil importing, and meaningful food importing countries like Pakistan– and high debt distress squeezing spending in the public sector– with meaningful expenditure going into servicing debt– while high fuel and food prices, with strong penetrating effects into a number of sectors determining the core inflation, along with high food and fuel prices, along with high cost of imports, altogether not putting any extraordinary pressure through the channel of aggregate demand on inflation; in turn, leaves little room for arguing for tight monetary policy stance.
A lot of growth continues to be sacrificed in the process, while austerity policies– both monetary austerity policy in the shape of extraordinarily high policy rate, and IMF programme demands of reaching a primary surplus– continue to build-up stagflationary headwinds. Since the pandemic has increased quite sharply in a few years, income and wealth inequality have also increased.
This has overall had damaging effects on economic empowerment of the demos, which has likely further weakened the strength of democracy in the country. One consequence of this, for instance, has been weakening of political voice, while vested interests gaining all the more profits since the start of the pandemic due to both over-profiteering, have likely gained more public policy influencing weight against calls for greater taxation of the rich.
The policy of monetary austerity needs to be reversed, with policy rate decreased in rather quick, and meaningful depths, to allow greater economic activity, and reduced pressures in terms of debt distress, balance of payments pressures, and imported- and cost-push inflation. Highlighting the wrong diagnosis that allowed for greater monetary tightening to reduce inflation, Nobel Prize-winning economist Joseph E. Stiglitz highlighted in a recent Project Syndicate (PS)-published article ‘A victory lap for the transitory inflation team’ that the transitory nature of inflation at the back of supply-side shock, ushered in disinflation (which is the decrease in inflation rate) when the supply shortages were met, and not mainly due to interest rate hikes.
It is exceedingly important that policymakers on both sides of the table– the IMF, and country policymakers– should shift away from their otherwise clear miscalculation, which emphasizes monetary austerity to control inflation, and shift towards a non-austerity, counter-cyclical policy to control inflation, in turn unclogging supply-side bottlenecks, and strongly diminishing their feeding into inflationary pressures.
The article pointed out in this regard ‘As the world was recovering from the pandemic, inflation shot up, owing to widespread disruptions to global supply chains and sudden changes in patterns of demand. While the demand shifts might have posed a challenge to price stability even in the best of times, the breakdown in supply chains made matters worse. The market could not respond immediately to the new demand patterns, so prices increased. … Once it was supplied… and prices came down – disinflation set in. …Of course, central bankers will pat themselves on the back. But they had little role in the recent disinflation. Raising interest rates did not address the problem we faced: supply-side and demand-shift inflation. If anything, disinflation has happened despite central banks’ actions, not because of them. … But over the ensuing two years, careful studies of the timing of price increases and the magnitude of aggregate-demand shifts relative to aggregate supply largely discredited the inflation hawks’ aggregate demand “story.” It simply did not account for what had happened. Whatever credibility that story had left, it has now been further eroded by disinflation. Fortunately for the economy, team transitory was right. Let us hope the economics profession absorbs the right lessons.’
Even more so, supply-shortages are overwhelmingly the main cause of inflation in developing countries like Pakistan, where compared to developed countries, miniscule level of stimulus was provided during the pandemic, and yet have seen an acutely tight monetary policy stance. This policy has not allowed unclogging supply-side bottlenecks, and has also added significantly to imported- and cost-push inflationary channels.
Renowned economist, James K. Galbraith, for instance in his recent PS-published article ‘Why mainstream economics got inflation wrong’ highlighted the miscalculation of leading economists by seeing inflation as mainly an aggregate-demand-determined phenomenon, as follows: ‘In his November 7, 2023 New York Times newsletter, the economist Paul Krugman asks a good, albeit belated, question: Why did so many economists get the inflation outlook wrong? After all, the near-consensus among mainstream economists in recent years was that inflation would persist– and even accelerate– and that this justified substantial interest-rate hikes by the US Federal Reserve. Yet the quasi-inflation of 2021-22 proved transitory. …Consider just how often mainstream economists get things wrong– not only small things, but very big ones. Remember their famous failure to foresee the 2007-09 financial crisis, or the woefully ill-advised turn to austerity in 2010? …The misdiagnosis of inflation in 2021-22 was merely the latest episode in a long-running series of failures. The question we should be asking, then, is whether there is something wrong with mainstream economics. Mainstream economists should perhaps re-examine their core beliefs, or maybe we need a new “mainstream” altogether.’
In the light of above, it is therefore exceedingly important that policymakers on both sides of the table– the IMF, and country policymakers– should shift away from their otherwise clear miscalculation, which emphasizes monetary austerity to control inflation, and shift towards a non-austerity, counter-cyclical policy to control inflation, in turn unclogging supply-side bottlenecks, and strongly diminishing their feeding into inflationary pressures.