Stagflation – Risks and Policy Responses

The global economy is showing signs of serious slowdown due to overlapping crises including the Russia-Ukraine war, the Covid-19 pandemic, the Chinese real estate crisis and the global tightening of monetary policy. In June, the World Bank revised down the growth forecast for 2022 to 2.9% from its January forecast of 4.1%.

The slowdown has been accompanied by a surge in inflation around the world, with global median consumer price inflation (CPI) reaching around 7.8% on an annual basis (YoY), the highest since 2008, according to the month of April. 2022 data. The emergence of an international environment of weak growth and a significant rise in inflation have raised fears of stagflation; a period of low growth combined with high inflation.

The effects

A stagflationary global environment could further weaken global economic growth while increasing inflation. To fight inflation, many central banks, including the US Federal Reserve, the Bank of England and the European Central Bank, resorted to monetary tightening measures. Raising global interest rates as a direct attempt to anchor inflation expectations will further dampen economic growth, thereby increasing borrowing costs globally. This results in a bearish business cycle, as higher borrowing costs will result in lower investment. The effects for developing countries could be more pronounced because inflation will hit the poorest and most marginalized the most. Weak global growth will reduce export earnings in these markets, while rising global commodity prices will increase import spending, leading to macroeconomic imbalances.

Risks for Sri Lanka

A global stagflationary environment may aggravate Sri Lanka’s current economic crisis, restricting growth and increasing inflation. Higher global borrowing costs will be detrimental to Sri Lanka’s future growth when the country resumes international borrowing once an IMF agreement is in place. Rising commodity prices could further increase food insecurity in the country, with the World Food Program reporting that 25% of the population is food insecure.

Higher commodity prices will also increase import spending while lower global demand could reduce export earnings, widening the current account deficit. However, if global inflation is transitory, the effects on the current account would be ambiguous. The global economic slowdown will lead to lower demand for commodities such as oil, which could reduce import spending, but also reduce demand for Sri Lankan exports.

Due to rising inflation and declining growth, the Sri Lankan economy is approaching stagflation. Growth expectations for the country plunged after the sovereign default, the economy is expected to shrink -7.8% in 2022 and -3.7% in 2023 according to the World Bank. The combination of myopic “organic” agricultural policy, the pass-through of inflation from the 80% depreciation of the Sri Lankan rupee, expansionary monetary policy, and global market conditions have resulted in a inflation at 59% in June (YOY) (Figure 2).

Tighter global economic conditions as well as domestic supply-side factors such as food and fuel shortages will continue to drive inflation in the country. Raising key rates to fight inflation will result in lower investment. These factors, combined with political instability, lower than expected remittances and lower productivity due to acute shortages of essential items, will further tighten the Sri Lankan economy, pushing it into stagflation. .

Policy Options

Sri Lankan policy makers are constrained in this economic environment. The country will have to impose austerity measures to benefit from an extended financing facility from the IMF.

These measures will include tax reforms to increase government revenue, reduce non-essential government spending and reduce subsidies. While a fiscal stimulus package is out of the equation, the country must target the most vulnerable groups by providing emergency grants, as rising inflation and job losses have led to a decline in the standard of living, especially among vulnerable segments of the population.

Due to financial constraints, Sri Lanka will need to seek additional bilateral and multilateral assistance to secure funding for targeted short-term “in-kind” transfers, such as food stamps. It is also imperative to have a bridging financing arrangement, to import essentials like fuel, so that supply shortages are reduced. This should help keep productivity intact and inflationary pressure under control.

Monetary tightening should also continue. CBSL raised interest rates by 700 basis points in April this year. Interest rates were raised by an additional 100 basis points in July to control the rise in inflation (Chart 3). Monetary policy decisions must be communicated very clearly in order to strengthen the anchoring of inflation expectations. Anchored inflation expectations would limit a wage-price spiral to control inflationary pressures so that production costs do not rise further.

Due to a global economic slowdown, rising commodity prices and high borrowing rates, Sri Lanka can expect a challenging external environment next year. Policymakers will need to understand these global challenges and make pragmatic economic decisions to minimize further damage to the economy.

The author is a research officer working on macroeconomic policy, poverty, and social welfare research at the Institute of Policy Studies.