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  • The strengthening of the dollar and its effects on emerging markets

    The strengthening of the dollar and its effects on emerging markets

    The Dollar has just gone up by around 19%, according to the Dollar Index (DXY), which is measures the strength of the USD relative to a basket of other foreign currencies. This simply means that it is now more expensive to buy dollars, and dollars can buy more of other currencies. To put things into context, the dollar is now at parity with the euro ($1 could be exchanged for €1), for the first time in 20 years.

    Figure 1: DXY graph for 2022

    So why has the dollar been strengthening so dramatically?

    Inflation in the US has spiraled out of control this year reaching up to 9.1% in June 2022, almost 5 times the Federal Reserve’s target rate of 2%. The pandemic has caused mass food supply chain disruptions causing food prices to rise. The Russian invasion of Ukraine has led to a global spike in energy prices. Fertiliser shortages from Ukraine, topped with poor harvests and livestock illnesses, have jacked food prices up even higher. The daunting effects of international crises have spilled over to domestic households in the USA and consumers are paying the price.

    In order to combat the rising inflation, the Fed has taken a hawkish monetary policy stance to keep inflation under control. By raising interest rates, borrowing costs would increase and in theory, this would reduce demand, easing the upward pressure on prices. Hence in just 6 months, the Fed has raised interest rates from 0.25% to a staggering 3.25%, with aggressive rate hikes of 75 basis points (0.75%) in June, July, and September. And the Fed doesn’t aim to stop there just yet – it is expected that the Fed will raise their interest rates to 5% by March 2023 in order to curb the two-decade-high inflation.

    Figure 2: Federal reserve interest rates in 2022

    When the Fed raises its interest rates, the demand for the greenback increases as investors worldwide seek to profit from higher short-term interest rates. These inflows of foreign funds into the US are known as “hot money”. To better illustrate this mechanism, foreign investors could get higher returns when they deposit money in a US bank, rather than in a European bank, when interest rates in the US are higher. As such, investors are more inclined to exchange their money for dollars to be deposited. Following the mechanism of demand and supply, the value of the currency would then gain strength.

    Interest rates aren’t the only factor driving up the demand for the USD – stocks, bonds, real estate, and cryptocurrency are underperforming and have just become riskier to invest in. The USD benefited from a confluence of recent events – volatile financial markets, supply chain issues, global inflation, etc. With less confidence to invest in riskier assets, investors opt to place their money on the dollar which is regarded as their safe haven, an asset that could retain or even increase its value during an economic downturn.

     

    How is this important to other countries?

    Being the world’s reserve currency, the dollar plays a significant role in the international market. Most international financial transactions take place using the USD – a large portion of international loans and about 60% of international and foreign currency liabilities are denominated in U.S. dollars, USD. With the dollar’s global significance, the impact of its strengthening reaches beyond its borders and affects financial markets around the world.

    Among them, emerging markets (EM) have been hit particularly hard by the stronger dollar. Emerging markets are generally developing economies that are transitioning to being “developed” through industrialisation, such as Brazil, Malaysia, China, and Pakistan. Despite experiencing rapid economic growth, most open emerging economies are price takers when it comes to international trade – their economies are not significant enough to affect the global market.

    Imported inflation and trade troubles

    In emerging economies, dollar strength translates into higher import costs. Due to the dollar’s stability and store of value, most key commodities such as crude oil, wheat, and copper are priced in dollars when traded. With the USD on the rise, the purchasing power of non-US currencies declined and imports became more expensive for EMs. Hence, there arises a concept that a higher-valued dollar exports inflation to other economies. Annual inflation in Argentina skyrocketed to a rate of 50%, and Turkey at 70%. Countries such as Turkey, Egypt, and Kenya are deemed to be at financial risk due to their heavy reliance on food and energy imports while experiencing major current account deficits.

    A significant rise in the dollar would in turn depress global trade growth as countries become less engaged in trade, in light of spiking commodity prices. For most developing countries that are especially dependent on global trade, the value of their GDP would likely take a hit. This is unfavourable for China – small and medium enterprises may experience a squeeze in profitability as the renminbi weakens against the dollar. It would likely produce knock-on effects and exacerbate the situation in EMs given their ties with Chinese supply chains and export markets.

    However, this may not be the case for export-led EMs. On the flip side of imports being more expensive, EMs exports become cheaper for foreign buyers. Increased foreign demand for exports means GDP would increase, which helps to offset other negative impacts of the stronger dollar. Commodity-exporting economies could also benefit from dollar-strengthening. As the world’s largest copper exporter, Chile saw its currency gain 8% in the first quarter since the dollar’s value was raised. However, the Chilean Peso dropped afterward due to slowing world copper demand stemming from production cuts in China.

    Capital flight and dampened economic growth

    Most emerging economies rely heavily on foreign investments as it forms the basis for businesses and the economy to grow. However, as the US hikes its interest rates, foreign funds totaling more than $38bn have pulled out from EMs within five consecutive months in 2022, indicating the longest period of net outflows since 2005. The US has become a more attractive destination to secure funds as federal rates have risen. Fears of a recession have also led investors to retrench their funds from riskier EMs and flee to safer assets.

    To remain competitive, EMs have to follow in the footsteps of the US and raise their interest rates. In other words, higher returns have to be promised to avoid capital flight from an EM to less-risky US assets. This leads to a dilemma for emerging economies – rate hikes are ideal to protect foreign investments, but on the other hand, they would increase borrowing costs. This would dampen aggregate demand and lead to downward economic growth, pushing some EMs to be at risk of a recession.

    Debt becomes more expensive 

    EMs rely on debt to finance expenditures in both private and public sectors, and they repay the money slowly over time with interest rates. They may take out debts in the form of government-issued securities or direct loans from financial institutions.

    A feature of debt is that they are often dollar-denominated, due to the fact that lenders deem the dollar far less volatile than currencies of emerging markets. Since the dollar has strengthened against other currencies, it became more expensive for EMs to service their debts. This is because emerging countries have to convert their domestic currency into USD to pay off most of their debts, meaning additional financial stress is placed on emerging markets. When USD: MYR = 4.0, an initial debt of $1000 could be paid back with RM4000, but when the exchange rate rises to 4.7, a larger figure of RM4700 is needed.

    As the Covid-19 pandemic had pushed borrowing in emerging economies to an all-time high, the financial stress arising from a more expensive debt has been magnified. During the pandemic, huge expenditures on fiscal stimulus, coupled with lowered tax revenue due to unemployment, have resulted in extensive government borrowing. In 2020 alone, debt amounted to 207% of the GDP in emerging economies. With a quarter of the debt being dollar-denominated, the rise in USD has accounted for a major increase in debt repayment figures by emerging economies.

    Sri Lanka just defaulted on its foreign debts in April, and countries such as El Salvador, Ghana, Pakistan, Tunisia, and Egypt are at risk of defaulting too, according to statistics from Bloomberg. When the risk of default is high, bond yields also rise, meaning that dollar-denominated debt has just become an even bigger burden for emerging markets. Governments borrow money from investors to finance their expenditures, by selling bonds and offering each bond with returns (known as yields). Bond yields typically increase to compensate for the increased risk of defaulting (not paying) on the bond. Therefore, because of the financial stress that EMs are experiencing, the default risks of EM bonds have increased. Hence, higher bond yields have to be offered to entice investors.

    Conclusion

    The strengthening of the dollar has just made the situation for EMs recovering from the pandemic much more complicated – imported inflation leading to trade decline, international capital flow reversals, and heavier debt burdens.

    Some argue that despite the Fed’s mandate to solve domestic issues, it should take its decision’s impact on the rest of the world into account. This is because economies have become much more interdependent on each other than before, as a result of financial and trade globalisation, said Mr. Obstfeld, a U.C. Berkeley economist. However, most economists hold the stance that despite the fallouts of a stronger dollar, the effects on other countries would be even worse if inflation in the US is not lowered to a targeted level.

    So if pushing the dollar up is necessary, how could EMs minimise the negative impacts imposed on them? The increasing reliance on floating currencies may offer an answer. As opposed to pegging currencies in the past, EMs have now gained greater leverage over managing the value of their currency by utilising deeper foreign-exchange reserves. Some EMs such as Brazil are already responding to the Federal Reserve’s rate hikes with rate hikes of their own which has effectively countered inflation and currency declines against the USD. So far, some EMs are demonstrating astounding resistance to the vicious global financial conditions. The IMF has forecasted that EMs are expected to outgrow major economies this year and next.

    Not all EMs however enjoy the stability that some of their counterparts experience. A strong headwind is approaching not only these EMs, but the world as a whole.

    (1740 words)

    References:

    Bertaut, C., Beschwitz, B.von and Curcuru, S. (2021) The International Role of the U.S. Dollar, The Fed – The International Role of the U.S. Dollar. Available at: https://www.federalreserve.gov/econres/notes/feds-notes/the-international-role-of-the-u-s-dollar-20211006.html (Accessed: November 2, 2022).

    Best, R. (2022) How the U.S. dollar became the world’s reserve currency, Investopedia. Investopedia. Available at: https://www.investopedia.com/articles/forex-currencies/092316/how-us-dollar-became-worlds-reserve-currency.asp#:~:text=The%20Bottom%20Line,-The%20reserve%20status&text=The%20trust%20and%20confidence%20that,currency%20for%20facilitating%20world%20commerce. (Accessed: November 2, 2022).

    Cohen, P. (2022) The dollar is strong. That is good for the U.S. but bad for the world., The New York Times. The New York Times. Available at: https://www.nytimes.com/2022/09/26/business/economy/us-dollar-global-impact.html (Accessed: November 8, 2022).

    Emerging markets look unusually resilient (2022) The Economist. The Economist Newspaper. Available at: https://www.economist.com/finance-and-economics/2022/10/13/emerging-markets-look-unusually-resilient (Accessed: November 3, 2022).

    Estevao, M. (2022) Three ways a strong dollar impacts emerging markets, World Bank Blogs. Available at: https://blogs.worldbank.org/voices/three-ways-strong-dollar-impacts-emerging-markets (Accessed: November 1, 2022).

    Fowers, A. (2022) What is Causing Inflation: The Factors Driving Prices High Each Month, The Washington Post. WP Company. Available at: https://www.washingtonpost.com/business/2022/07/26/inflation-causes/ (Accessed: November 2, 2022).

    Gopinath, G. and Gourinchas, P.-O. (2022) How countries should respond to the strong dollar, IMF. Available at: https://www.imf.org/en/Blogs/Articles/2022/10/14/how-countries-should-respond-to-the-strong-dollar (Accessed: November 2, 2022).

    Hartman, M. (2022) Why the U.S. dollar is so strong right now, Marketplace. Available at: https://www.marketplace.org/2022/08/29/why-us-dollar-is-strong/ (Accessed: November 1, 2022).

    Kalemli-Özcanis, Ş. (2021) The Federal Reserve, emerging markets and private debt – IMF F&D, IMF. Available at: https://www.imf.org/en/Publications/fandd/issues/2021/06/federal-reserve-emerging-markets-private-debt-kalemli-ozcan#:~:text=In%20emerging%20markets%2C%20a%20disproportionate,constitute%20the%20remaining%2035%20percent. (Accessed: November 2, 2022).

    Lee, Y.N. (2021) Rising debt in emerging markets could push back Covid recovery and widen gap with developed world, CNBC. CNBC. Available at: https://www.cnbc.com/2021/05/24/moodys-analytics-on-high-debt-covid-recovery-in-emerging-markets.html (Accessed: November 2, 2022).

    Lubin, D. (2022) A stronger dollar might hit emerging economies harder this cycle, Financial Times. Financial Times. Available at: https://www.ft.com/content/3e8737a0-b4c1-4e7c-b93f-f646e3c699dd (Accessed: November 1, 2022).

    Maki, S. (2022) Why Developing Countries Are Facing a Debt Default Crisis, Bloomberg.com. Bloomberg. Available at: https://www.bloomberg.com/news/articles/2022-07-07/why-developing-countries-are-facing-a-debt-default-crisis (Accessed: November 2, 2022).

    Otsuka, S. (2022) Superstrong Dollar Threatens Debt Crisis Across Emerging Economies, Nikkei Asia. Nikkei Asia. Available at: https://asia.nikkei.com/Business/Markets/Currencies/Superstrong-dollar-threatens-debt-crisis-across-emerging-economies#:~:text=A%20quarter%20of%20government%20debt,up%20from%2015%25%20in%202009. (Accessed: November 2, 2022).

    Person and Cambero, F. (2022) Chile currency plunge, inflation rattle Latin America’s copper king, Reuters. Thomson Reuters. Available at: https://www.reuters.com/markets/commodities/chile-currency-plunge-inflation-rattle-latin-americas-copper-king-2022-07-11/ (Accessed: November 1, 2022).

    Person and Karin Strohecker, S.R. (2022) The dollar problem: Emerging markets count the costs, Reuters. Thomson Reuters. Available at: https://www.reuters.com/business/finance/dollar-problem-emerging-markets-count-costs-2022-05-11/ (Accessed: November 1, 2022).

    Team, T.I. (2022) Emerging market economy definition: Examples and how they work, Investopedia. Investopedia. Available at: https://www.investopedia.com/terms/e/emergingmarketeconomy.asp (Accessed: November 1, 2022).

    Tepper, T. (2022) Federal Funds Rate history 1990 to 2022, Forbes. Forbes Magazine. Available at: https://www.forbes.com/advisor/investing/fed-funds-rate-history/ (Accessed: November 2, 2022).

    Tepper, T. (2022) Why is the U.S. dollar so strong right now?, Forbes. Forbes Magazine. Available at: https://www.forbes.com/advisor/investing/strong-dollar/ (Accessed: November 2, 2022).

    Wheatley, J. (2022) Emerging markets hit by record streak of withdrawals by foreign investors, Subscribe to read | Financial Times. Financial Times. Available at: https://www.ft.com/content/35969b19-86db-4197-a419-b4a761094e9a?shareType=nongift (Accessed: November 1, 2022).

    Researcher(s): Alexander Chen, Eunice Jong

    Reviewer(s): Nasir Ali

    Editor(s): Maryam Nazir Chaudhary

    Designer(s): Erdina Mysarah

  • Everything you need to know about Stagflation – and is it happening in Malaysia?

    Everything you need to know about Stagflation – and is it happening in Malaysia?

    Key terms:

    What is Core CPI?

    The Core Consumer Price Index (CPI) measures the changes in price for consumer goods, except for food and energy.

    This measure is used instead of the normal CPI, since it better reflects long-term inflation, as food and energy prices are relatively more volatile.

    What is GDP?

    Gross Domestic Product (GDP) reflects a country’s ability to produce goods and services.

    Based on the GDP growth rate, we can see that GDP shrunk in 1974-75, and again in 1980 and 1982, which matches the high inflation we saw earlier.

    The Year 2022 is quite miserable from an economic standpoint. According to the IMF, global economic activity is experiencing a sharper-than-expected slowdown, with a record-breaking inflation rate since decades ago. The ongoing tightening of monetary policies, the Russia-Ukraine War and the lingering Covid-19 pandemic, make the economic outlook dimmer. (IMF, 2022)

    Global growth is forecasted to slow from 3.2% in 2022 and 2.7% in 2023. This is the weakest growth profile since 2001, except for the global financial crisis and the acute phase of the Covid-19 pandemic. Low growth, high inflation and high unemployment are early signs of stagflation and it was accurately indicated in the past 1970s Oil Crisis.

    Now the question that lingers on us is “What’s the direction of the economy for the next 5 years: are we heading towards stagflation?”

    Introduction

    Stagflation is a phenomenon where stagnation (when the economy is not growing) is combined with inflation (when prices rise). Interestingly, people don’t believe in stagflation, even economists in the early 60s, as it was considered a rare economic phenomenon back then. But people’s minds changed in the 1970s, during the time they had to experience the inevitable stagflation. (Statista, 2022)

    Definition

    Stagflation occurs in the existence of slow growth, high unemployment, and high inflation. Economic policymakers have a consensus that stagflation is the most difficult to handle, as efforts to correct one factor can exacerbate another. To illustrate this, governments and central banks can loosen the fiscal and monetary policies to cope with the slow economic growth, but it will certainly lead to an increase in the money supply that further pushes up inflation.

    History of Stagflation

    The term “Stagflation” was first used by Ian Macleod in 1965, to reference the phenomenon of high inflation and unemployment in the United Kingdom. The terminology was brought up again in the U.S. during the 1970s oil crisis, which caused a recession that was five consecutive quarters of negative GDP growth. At the same time, inflation doubled in 1973 and hit double digits in 1974, and unemployment reached 9% by May 1975.

    Stagflation was once thought to be impossible. Mainstream economic theories that dominated academic and policy circles for much of the 20th century tried to exclude it from their models. Essentially, world economics before 1970 was dominated by the infamous economic theory of the Phillips Curve, which developed in Keynesian economics and portrayed macroeconomic policy as a trade-off between unemployment and inflation.

    Phillips Curve

     

    Source: Federal Reserve Bank of St. Louis (2020)

    The Phillips curve is an economic theory that inflation and unemployment have a stable and inverse relationship. It claims that with economic growth comes inflation, which should lead to more jobs and less unemployment.

    In 1958, New Zealand economist Alban William Housego Phillips, also known as William Phillips, found the inverse relationship between unemployment and the rate of change in money wage, which was the archetype for the Phillips Curve.

    While in 1960, Richard Lipsey, Paul Samuelson and Robert Solow provided further support for Phillips’ findings, who officially coined the terminology of “Phillips Curve” by linking price inflation (instead of wage inflation) with the unemployment rate. Samuelson and Solow believed they could fine‐tune the economy by choosing a socially optimal point on the Phillips curve, at least in the short run.

    Although Samuelson and Solow stated that their analysis pertained to the short run, there was a strong consensus that governments thought the Phillips curve was the permanent tradeoff between inflation and unemployment (ignoring the outliers on the graph above). That belief fostered the idea that mild inflation was beneficial in reducing unemployment. As a result, the inflation rate increased from 1.2% in 1962 to 5.8% in 1970.

    With high and variable inflation in the 1970s, reaching 13.5% in 1980, the Phillips curve lost its lustre as both inflation and unemployment soared. After that, the voices questioning the malfunction of the Phillips Curve arise and allow room for stagflation to stand from the economic point of view. However, the Phillips Curve has not been eliminated even today, as Fed Chairman Jerome Powell believes the Phillips Curve “continues to be meaningful for monetary policy” even though the strength of the correlation between unemployment and inflation “has weakened”. (Cato Institution, 2020)

     

    How stagflation happens

    The Causes of Stagflation

    In the simplest term, stagflation happens when growth is slow or negative, and there is high unemployment and high inflation. The presence of these 3 factors is considered the leading indicator that results in stagflation. The cause of stagflation is complicated and academics are yet to have one concrete theory to explain, hence, the theories below are among the mainstream in explaining the causes of stagflation.

    Supply Shock Theory

    The supply shock theory posits that stagflation occurs due to a sudden decline in the supply of products and services. This causes prices to increase dramatically, affecting lower profit margins for most companies and ultimately slowing economic growth. For example, if factories suddenly go bust, this would significantly reduce the available products in the market.

    Poor Monetary Policies Theory

    This theory states that stagflation is often the result of poor monetary policy. It is because the central bank’s and government’s attempt to interfere and regulate the economy will instead worsen a crisis. For instance, the US focused on maximum employment prior to the 1970s, by introducing loose monetary policies such as the Employment Act of 1946, which inadvertently caused inflation to grow and affected the employment market and economic growth.

    Government interventions can also cause stagflation, for example, the Nixon strategy of devaluing the dollar instituted wage and price freezes known as the Nixon Shock. But in the end, due to the conflicting objectives between the central banks and legislators who tried to keep inflation in check, this pressed down unemployment and high economic growth at the same time.

    Demand-Pull Stagflation Theory

    Proposed by economist Eduardo Loyo, the demand-pull stagflation theory suggests that stagflation can occur exclusively from monetary shocks without the need for a supply-related shock. It is most likely to occur when governments tighten monetary policies, such as raising the federal interest rate or a reduction in the money supply.

    Cost-Push Stagflation Theory

    The cost-push stagflation theory sees supply-side inflation as a key driver of stagflation. In this case, rising prices lead to unemployment since they usually reduce the profit of the companies, which leads to reduced economic output. Supply-side inflation can also be impacted by things like increases in wages or labour shortages.

    End of the Gold Standard

    Historically, Nixon’s ending of the convertibility of US dollars to gold marked the end of the Bretton Woods System, and it was considered to be one driver of the 1970s stagflation. The gold standard made the US vulnerable in gold runs, as there were more dollars in foreign hands than gold reserves in the US. (In 1966, non-US central banks held $14 billion, while the US had only $13.2 billion in the gold reserve.)

    Nixon closed the gold window that allowed for the exchange of dollars for gold in 1971, and US dollars officially decoupled from gold in 1976. Both moves devalued the dollar, which impacted inflation and economic growth and led to stagflation. (IMF, 1971)

     

    The Mechanism of Stagflation

     

    Click Here to View Diagram in Higher Quality

     

    Source: Seeking Alpha (2022)

    Stagflation is triggered by a supply shock. A supply shock is an unexpected event that changes the supply of a product or commodity, resulting in a sudden price change. It can be negative, resulting in a decreased supply. Assuming aggregate demand is unchanged, a negative supply shock will cause a price increase in products and services. When the price of goods gets expensive, it decreases the aggregate demand of the economy, which causes the utilisation and production of the economy to slow down. Businesses might experience a decline in profit as demand plummets, and to cut costs to survive, employees get laid off, which causes the unemployment rate to spike. As the unemployment rate increases, wages will decrease due to more people actively searching for work. Also, the lower wages indicate lower disposable income for workers and forces them to spend less, further reducing the aggregate demands of the economy. (Business Insider, 2022)

    To sum up, the increasing inflation force came from the supply shock reducing the supply of the economy, while the rising unemployment rate was due to lesser aggregate demand and slowdowns in businesses. Ultimately, the impact is lower economic output, illustrated by stagnant or negative growth in GDP. (Seeking Alpha, 2022)

     

    Example of stagflation in US History 

    Stagflation broke the traditional economist’s beliefs, where unemployment and inflation have an inverse relationship.

    High Inflation

    > Caused by a spike in West Texas Intermediate crude oil, which brought about higher energy costs. (Investopedia, 2022)

    The oil crisis of the 1970s is the most frequently used illustration of stagflation. In response to Western backing for Israel during the Yom Kippur War, the Organisation of the Petroleum Exporting Countries (OPEC) imposed an oil shipping embargo on the United States and Israel’s European allies in October 1973.

    The rapid rise in oil prices by almost 300% resulted from the oil embargo. That led to significant problems in the country’s car-dependent economy, as oil prices remained high even after the embargo ended in March 1974. This led to a protracted period of stagflation during which high oil prices caused inflation to rise quickly, unemployment to rise, and the economy to stagnate. Manufacturing jobs were being relocated outside of the United States to save on labour costs and the rising cost of the Vietnam War.

    Real wages stopped growing as a result of the U.S. economy shifting from manufacturing to lower-paying service jobs, which also affected consumer confidence and spending, aggravating the crisis.

    To combat stagflation in the 1970s, President Richard Nixon devalued the dollar and enacted price and pay freezes. Jeremy Siegel, a well-known economist, believes that this plan is among the biggest failures in American macroeconomic policy because it was unsuccessful. The Federal Reserve’s expansion of the money supply, in the opinion of many economists today, was the primary cause of the stagflation crisis of the 1970s.

    At the time, it was thought that high inflation resulted in low unemployment, but in the 1970s, both rates climbed. To stop stagflation, the economic policy had to be revised to place more emphasis on low unemployment and price stability. (Seeking Alpha, 2022)

    Source: U.S. Bureau of Labor Statistics

    High Unemployment (>5%)

    The unemployment rate is measured by the number of people actively looking for work, but are not employed. The unemployment rate first spiked in 1975, and again in 1982-83. Throughout 1975-85, although unemployment rates fluctuated, the rate stayed above 5%.

     

     

    Is the US facing stagflation in 2022?

    As we have observed the data for stagflation in the 1970s, let us look at the recent data.

    High inflation: ✅ (has fulfilled the criteria)

    Based on the graph below, core inflation typically hovers between 1 to 3%.

    Source: U.S. Bureau of Labor Statistics

    Core inflation hit 6.3% in September 2022, which is among the highest figures we have seen in recent years. Although the core inflation is still lower compared to 1982, it is worrying that it has been abnormal in recent years.

    High unemployment: ❌ (has yet to fulfil the criteria)

    Source: U.S. Bureau of Labor Statistics

    During the Covid-19 pandemic, unemployment in the US spiked to 14.7% in April 2020. Hence, the US government introduced the CARES act, which helped businesses to retain employees.

    However, unemployment is supported by government intervention, and would not be sustainable in the long term, once the government stops providing employment assistance.

     

    Data Source: U.S. BUREAU OF LABOR STATISTICS

     

    Low growth: ❌ (has yet to fulfil the criteria)

    Source: U.S. Bureau of Labor Statistics

    Although the United States GDP fell by 3.4% during the pandemic in FY2020, it quickly recovered in 2021, with a 5.7% GDP growth rate.

    However, stimulus packages and inflation are temporarily fueling the US GDP growth, which can be unsustainable. Therefore, we would still need to look into this closely in the following years. (Forbes, 2022)

    Based on the analysis above, there is no sufficient evidence to conclude that stagflation is happening in the United States, at least in the near future. (U.S. General Services Administration, 2022)

     

    Is stagflation happening in Malaysia?

    Core Inflation: High ✅

    Source: Trading Economics

    Malaysia’s Core Inflation hit a record high of 4.0% in September 2022. Although it is still lower than the 6.3% faced in the United States, it is showing a worrying uptrend. (Trading Economics, 2022)

    The weakening Ringgit and global inflation setting are causing increased inflation in Malaysia.

    Unemployment: High but dropping ❌

    Source: Trading Economics

    Unemployment spiked to >5% when the pandemic hit in 2020, then gradually dropped to 3.7% in August 2022. However, it is still on the higher side compared to the 3-3.5% maintained throughout 2012-2020. (Trading Economics, 2022)

    GDP Growth: ❌

    Source: Trading Economics

    Malaysia’s GDP grows at around 5%. However, the circumstances in the past few years have caused the rate to be unstable. Currently, the GDP growth rate is rapidly increasing, recently hitting 8.9% for Q2 2022. (Trading Economics, 2022)

     

    Conclusion

    Responses to Stagflation

    It is challenging for both central banks and policymakers to address inflation, because focusing on one component of the issue may have a detrimental effect on another. For instance, raising interest rates raises borrowing costs and decreases demand, which lowers inflation but also slows GDP growth.

    1.   Monetarist Responses

    The monetary response is known as the most prevalent method taken by central banks around the world. Monetarists combat stagflation by lowering inflation even if doing so results in a temporary rise in unemployment and a slowdown in economic development. Between 1979 and 1984, the UK Conservative administration employed this tactic, which caused a recession.

    2.   Supply-Side Responses

    To combat cost-push inflation, policies like deregulation and suspending tariffs that help businesses by lowering costs and boosting efficiency could be utilised to enhance aggregate supply. However, because they are national initiatives to address global supply constraints, these methods are frequently disregarded.

    3.   Wage Control Responses

    If rising wages are the root cause of stagflation, pay controls might be put in place to slow down the rapid wage growth that is driving up prices and eroding corporate margins.

    4.   Waiting Responses

    Many economists think that doing nothing in the face of stagflation would be the wisest course of action. Stagflation can occasionally go away with time, but attempts to do so may trigger recessions with sharp drops in GDP. (Seeking Alpha, 2022)

    In short, the direction of the economy highly depends on how the three indicators play out. As of the current situation, the US is hit with two red flags of slow economic growth and high inflation, while the unemployment rate remains healthy. The scenario is more optimistic for Malaysia, as we have solid GDP growth and a low unemployment rate. Although the concerning factor for Malaysia is still the rising inflation, the problem arises on how soon the inflation will turn around, since the Bank Negara Malaysia (BNM) has risen to 100 basis points OPR from May 2022 to an OPR rate at 2.75%. Last, the market consensus foresees that BNM will continue to raise interest rates in 2023 to cool down inflation as well as managing inflation expectations.

     

    References

    Business Insider (2022) What is stagflation? Understanding the economic phenomenon that stifled growth through the 1970s. Available at: https://www.businessinsider.com/personal-finance/stagflation (Accessed: October 26, 2022).

    Cato Institution (2020) The Phillips Curve: A Poor Guide for Monetary Policy. Available at: https://www.cato.org/cato-journal/winter-2020/phillips-curve-poor-guide-monetary-policy#a-better-framework-for-monetary-policy (Accessed: October 26, 2022).

    Federal Reserve Bank of St. Louis (2020) What Is the Phillips Curve (and Why Has It Flattened)? Available at: https://www.stlouisfed.org/open-vault/2020/january/what-is-phillips-curve-why-flattened (Accessed: October 26, 2022).

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    Researchers: Alex Chong and Kok Chun Yik

    Reviewers: Nasir Ali and Sherilynn Ng

    Editors: Angellina Choo

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