US Inflation Becoming Everyone’s Problem

THE legal mandate of the US Fed is to preserve domestic price stability and enhance employment. It, however, does not envision any role for the Fed in keeping global economic stability. It is up to each country to prepare and swim through the tides. Though the post-World War 2 US-dollar centric global financial system accorded the US a de facto lender-of-the-last-resort role, this legal mandate and reality contradiction shows up when the US domestic economic environment is not in sync with global economic conditions. The challenge facing the world today once again focuses on this dilemma.

On May 12, US Federal Reserve Chairman Jerome Powell cautioned that getting the country’s inflation under control won’t be easy. The credit tightening process could cause economic pain, and he can’t guarantee a “soft landing,” meaning — to get the inflation rate back to 2 percent from the current 8.3 percent in April while keeping the labor market strong.

INFLATION VIRUS United States Federal Reserve Chairman Jerome Powell, Bangko Sentral ng Pilipinas Governor Benjamin Diokno, Finance Secretary Carlos Dominguez 3rd and Socioeconomic Planning Secretary Karl Chua

Most economists expect the US inflation rate for 2022 to be around 6.5 percent to 7 percent. Last week, the Fed Fund rate increased by half a percentage point to reach 0.75 percent to 1 percent. Markets expect the rate will increase by another half-point in June and keep increasing another four rounds until the end of the year. Depending on the inflation outlook and the quantum of rate interest in the remaining four meetings of the Fed, the end of the 2022 Fed Fund rate is estimated to be around 2.25 percent to 3.5 percent.

Many people have criticized the Fed for not raising the rate and stopping its bond-buying early when signs of inflation mounted in the second half of last year. Powell said that he is not sure how much difference it would have made if the Fed acted early. Still, he stressed that restoring price stability is his number one policy objective now, as the economy doesn’t work for anybody without price stability.

The US economy is going through an unusual period with many trouble spots, including an unsustainable wage growth from a tight labor market, inflation from supply-side disruption triggered by a confluence of factors such as the trade war with China and the Russia-Ukraine war. Moreover, the monetization of the historically high federal budget deficit of $5.90 trillion in fiscal 2020 and 2021 has created asset demand that pushes up inflation.

In 2021, the US home price rose 18.8 percent, the biggest increase in 34 years of data and substantially ahead of 2020’s 10.4 percent, according to the S&P CoreLogic Case-Shiller US National Home Price Index.

Resolving so many underlying inflationary forces will likely take some time, and the current US inflation outlook is uncertain. While most economists predict a peak Fed Funds rate of 3.0 percent to 3.5 percent, some predictions as high as 5 percent have surfaced.

Transmission mechanisms of a country’s inflation to other countries

Any inflation problem in a major economy has a spillover effect on other countries. There are two major transmission mechanisms for it to go overseas.

The first is through the current account trade channel. A major economy is often a key exporter of goods and services. Therefore, a higher domestic price will push up its export prices to other countries and raise the price level of the importing countries.

The second is through the capital account funds flow channel. The currency of a major country is often a reserve currency and invoicing currency in trade, and these functions create the natural demand for the major countries’ currency. When the central bank of a major country increases its interest rate, funds from other countries might flow to it to earn a higher return and weaken other countries’ currencies due to higher outflow. The capital movement prompted other countries to raise rates to match the higher rate of the major country to preserve domestic liquidity.

The US is not the biggest exporter of goods today, and its inflation export does not affect most other countries through the trade channel. The US dollar, however, is still the dominant global reserve and invoicing currency; hence, US inflation casts a shadow on other countries.

This round of global inflation has a feature markedly different from the earlier episodes. The developed countries lead the price hike. In April, the US inflation was 8.3 percent, the European Union was 7.5 percent, China was 2.1 percent, and developing countries like the Philippines and Indonesia were 4.9 percent and 3.5 percent, respectively. Many economists posited that the excessive quantitative easing of the developed countries in the pandemic is the cause of the puzzle.

In a smooth functioning global economy, reserve and invoicing currency are supposedly the anchor of price stability. Noted international currency expert Barry Eichengreen speculated that new currency arrangements would rise after the current crisis by moving toward more regional currencies in bilateral trade and foreign exchange reserves. The move could minimize the unwanted spillover effect of US or EU monetary policies on other countries.

PH in relatively good position, but staying alert is important

Philippine Central Bank Governor (BSP) Diokno cited several reasons for believing the country can weather the exchange rate pressure from US rate hikes.

First is the lower dependency on foreign debt: though the public debt has hit more than 60 percent of GDP, 70 percent of which is denominated in peso, and foreign currency denomination is just 30 percent.

Second is the hefty gross foreign exchange reserve of more than $108 billion as of March 2022. In addition, the steady annual $30 billion inflow of overseas workers and another $30 billion from BPO cushion the trade deficit running at $43 billion in 2021.

Third is the peso’s performance against the US dollar is in line with other regional currencies. As of May 10, the peso dropped 2.5 percent against the US dollar year-to-date, while Indonesian, Thailand and Malaysian currencies dropped 2 percent, 4 percent and 5.2 percent, respectively.

Behind the improved financial conditions of the country. Some issues merit close monitoring. First is the sharply higher trade deficit in the first quarter of 2022, $13.9 billion against $8.3 billion in the same period of 2021, a hefty 67 percent increase. The country’s current account deficit will hit 4.5 percent in 2022, a multi-decade high. The second is the foreign holding of the Philippine Treasury. It is known that some overseas funds have been invested in developing countries’ domestic bonds in the past few years to earn higher income when the 10 years US T-bond rate hovers at less than 1 percent. This holding might unravel with the US rate hike and trigger an outflow surge.

It is expected the BSP will increase interest in its May 19 meeting with Q1 GDP growing at the better than expected clip of 8.3 percent and inflation accelerating.

The current round of global inflation hit two commodities particularly hard, energy and food. Inflation on these two commodities disproportionately hits the poor and is politically sensitive. It should be noted that monetary policies help attenuate the demand side of inflation and minimize imported inflation. Still, the problems with these two critical commodities are more often related to supply. The supply-side problem in economics is often the Achilles heel of developing countries in their development efforts.

The US inflation has become everyone’s problem, and how to mitigate its adverse impact is a test for their economic managers.

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Also published in Manila Times. We welcome logical feedback and possibly working together with compatible frameworks. (idsicenter@gmail.com)