19th June 2022, Skopje – Supply and demand. Fundamental economic laws and basis of all economic principles. The interaction between goods and services supplied and demanded on the market determines the market equilibrium – the price. If supply increases, while demand remains the same – the price falls. If supply decreases, while demand remains the same – the price rises. The same holds for the demand.
The Great Inflation in the 1970s, which was an international phenomenon, was sparked mainly by the supply side. Throughout history, the Great Inflation was blamed on rising oil prices, “cheap money”, currency speculations, businessmen and unions seeking higher earnings. 1970s crisis in a nutshell: 1. it brought on high inflation rates; 2. lasted for more than a decade and 3. gave rise to an economic phenomenon – stagflation – stagnation accompanied by high inflation rates.
Supporters of Keynesisan theory ignored the possibility of stagflation back then, since high unemployment rates were not associated with low inflation. According to the Keynesian theory, stagnation and inflation were two opposites, mutually exclusive, with their relation seen through the so-called Phillips curve. The idea was that high prices give rise to higher earnings, higher earnings foster higher production, which entails expansion of capacities and employment increase. However, things did not unfold that way and the neo-Keynesians acknowledged that supply side inflation, in particular related to resources and commodities, can lead to slowdown of economic activity. Professor Edmund Phelps’ theory is in support thereof, showing that long-run Phillips curve is vertical at the “natural rate of unemployment”, which is not associated with inflation, but rather with the real factors to growth of the economy. He actually incorporated the inflation expectations in the Phillips curve, thus explaining that amid unchanged supply, increased money supply causes inflation, a theory close to the monetarists. Milton Friedman, a renowned monetarist at that time, argued that inflation is always and everywhere a monetary phenomenon, i.e. releasing more money in circulation than necessary in an economy inevitably leads to inflation. In the context of such economic debate, in order to put an end to the Great Inflation in the USA, the chair of the Federal Reserve was replaced, followed by an aggressive tightening of the monetary policy and raising interest rates to nearly 20%, including acceptance of a recession, before the inflation would return to low single digits. The debate whether stagflation was caused by the rapid and too rigid monetary tightening and market regulation still remains as open in the economic theory.
Ongoing Price and Energy Crisis vs. 1970s Great Inflation
Why such foreword, is the world threatened by a new crisis as the one in 1970s, to end up with high unemployment rates and recession? – Luckily, no. And yes, economies are burnt out as a result of the response to the severe recession which occurred during the pandemic. USA and EU have managed to get back to the pre-pandemic level in just a year, even exceeding it, as a result of the measures undertaken through the monetary and the fiscal policies. However, disrupted supply chains, high liquidity, weaker response of the supply in relation to the demand which has got back to the pre-pandemic level, all this has contributed for rapid increase of prices and inflation hitting its highest level in many countries in the last several decades.
As a result of persistent price pressures, disruption of the global chains, uncertainty triggered by the war in Ukraine, as well as normalization of the monetary policies, i.e. increase of cost of capital, the World Bank forecasts for the global growth to slow down to 2.9% this year. June forecasts imply significant deceleration by 1.2 p.p. in relation to January projections, or in relation to the 5.7% post-pandemic growth in 2021. Developing economies have already experienced a major setback to income growth and poverty reduction as a result of COVID-19 pandemic. Still, war in Ukraine heightens the challenges and they are expected to generate GDP growth of 3.4% in 2022 – or barely half of the 2021 growth rate and far below the average from 2011 through 2019. Growth forecasts for middle-income countries are similar, and they will see a sharp decline of growth of 1.3 p.p. relative to the January forecasts.
Inflation expectations are what makes this price crisis different from the 1970s Great Inflation. International financial institutions, markets, investors – despite the heightened uncertainty stemming from the war in Ukraine, they all expect for the inflation to stabilize next year, although higher than what we are used to in the past decade. In the medium term already, it is expected to return to the pre-pandemic low level. During the 1970s, the forecasts were upward. An example given by Nobel Prize winner Krugman on inflation expectations in the USA back then: workers expected higher prices, employers expected higher prices, therefore both agreed for much higher increase of wages than the output they created, which contributed to further putting pressure on the inflationary spiral and protracting the crisis.
I would like to mention few more elements distinguishing the ongoing developments from the 1970s, that being the readiness of the policy makers and much more mechanisms and safety nets being put in place throughout the years, in particular following the global financial crisis. Moreover, 1970s were characterized with a severe stock market crash and dollar depreciation, which now is not the case.
Beginning of the End of “Cheap Money”
As I have mentioned safety nets networks and policy makers, let’s go back to 2022. Major central banks have already started tightening the monetary policy. Federal Reserve have been the first to increase the policy rate, raising it by 75 basis points with the recent decision adopted few days ago, which is one of its most aggressive hike since 1994. They target the interest rate at 3.4% this year, raising to 3.8% in 2023, and are strongly committed to returning to the target inflation of 2% in the medium term. In addition, European Central Bank, although prudent in tightening the policy compared to FED, adopted decision in June on 25 basis points hike of its policy rate, reviewing its policy in September. They are all dedicated to returning the inflation to the target rate of 2%, which also means that “cheap money” era has come to an end.
What are the fiscal authorities to do in times when the monetary authorities increase the interest rates? – Following the pandemic, fiscal space to respond is narrowed, especially in the developing countries. Hence, when creating fiscal policies, this is also to be taken into account, considering the price rise expected on the capital markets. Fiscal measures should be put in place anyhow, but the fiscal response amid pandemic and in times of the price crisis is to be different, since the nature of the crisis is different, as are the current conditions for financing and implementing the measures.
Strength of demand in support of both inflation stabilization and vulnerable categories
“Targeted measures” is the magic word in each of the analyzes and the reports of the international financial organizations. This means determining exactly which target category of citizens and companies need the measures, thereby designing and implementing them as per the respective target group.
According to an IMF publication, fiscal policies should, during the ongoing crisis, be planned in line with the already existing social protection system, applied in the respective country. Recommendations on the fiscal measures are given as per three categories of countries: 1. having strong social protection in place, 2. with poor social protection, but no food and energy subsidies and 3. with poor social protection, as well as food and electricity subsidies.
Countries with a strong social protection system already in place, are advised not to take measures against the spillover of higher energy prices into the national economies. Targeted financial support for the vulnerable categories is also recommended. In case the existing social policy does nor provide support for middle-class households affected by the crisis – considering targeted one-time financial support is recommendable.
Countries with poor social protection system, with no food and energy subsides, are advised to expand and upgrade the social programs designed in times of COVID-19 crisis. Moreover, these countries are advised to use the ongoing crisis as a basis for reinforcing the social protection system.
Countries with poor social protection system, but already providing energy and food subsidies, are also advised to allow gradual spillover of global market prices into their economies, as well as to calibrate, through the existing fiscal space, the gap between import and retail prices.
Briefly said, although being greatly politically unpopular, it is recommended to allow the effectuation of the market forces of supply and demand, with support being provided to the most vulnerable categories. Price signals are crucial for both adequate demand response and beginning of the stabilization. Let us take the energy as an example therefor. Demand for energy is inflexible on the short run, while becoming flexible in the medium term, in particular as regards fuels, meaning that higher prices can lead to lower demand. Over time, prices will stabilize as a result of the reduced demand.
On the other hand, food is featured with even greater price inelasticity. Therefore, ensuring social security to the most vulnerable categories of citizens, is of great significance. We get back again to the term “precisely targeted measures”. For example, if low-income households use certain fuels for heating, the well-designed measures can impact the very price of these fuels. Reducing fuel and food taxes is not recommendable. On the contrary, tax collection should be geared towards protecting the vulnerable households. Reducing the taxes for all means also subsidizing those in no need of support, at the expense of the vulnerable categories of citizens.
IMF also advises taking the climate changes into consideration when designing the measures, given that fuels are one of the targets set therein.
A recent IMF survey demonstrates that most countries have already taken measures to reduce the spillover of global stock market prices into the national economies. Majority of the countries have undertaken at least one measure since the beginning of the year, i.e. 26 out of 31 developed economies and 45 out of 103 developing economies. The narrower fiscal space, as well as the already existing food and energy subsidies in the developing countries, are the very factors leading to the respective lower figures.
Domestic inflation cushioned by around a quarter this year
Our economy has a sound social protection system in place. By implementing the social reform in 2017, we became the first country in the region to introduce a guaranteed minimum income, coupled by the multiple social transfers, targeting different groups, also including electricity subsidies for the socially disadvantaged families.
However, despite all this, our Government has, so far, taken plenty of measures for the purpose of slowing down the spillover of the global stock market prices to our country. Those reading this column will surely notice that this is opposite of what was written above, however, I would like to stress that food and energy account for a large percentage in the Consumer Price Index (CPI) in our country, hence such response was necessary to slow down the inflationary spiral. The initial response was reflected via tax relief, support to energetic companies for slower increase of the electricity price, targeted financial support to the vulnerable categories, administrative restrictions, which will impact the prices, as well as energy saving measures.
In the period January – May 2022, inflation rate recorded upward trend, reaching 9.1%, thus reflecting the price pressures exerted on the supply, triggered by global factors, which spilled over to the domestic economy mostly through the rising prices of food products (12.8%), oil derivatives (30.7%) and electricity (9.4%). These categories accounted for 71% of the inflation growth during this period.
According to an analysis carried out by the Ministry of Finance, this inflation would have been much higher, if it was not for the prompt fiscal response through the anti-crisis measures. According to the available data from the State Statistical Office (SSO), in the first half of 2021, average price of electricity for households was Denar 4.37 per KWh excluding VAT, i.e. Denar 5.156 with 18% VAT. Having in mind that the electricity price in the period January – May 2022 is higher by 9.4% compared to the same period last year, the price, in the period January-May 2022, is accordingly Denar 5.641 per KWh with 5% VAT or Denar 5.373 with no VAT included. If 18% VAT is calculated thereon, the price would be Denar 6,340 per KWh, i.e. 22.9% increase instead of 9.4%, due to the reduced VAT from 18% to 5% Hence, electricity price surge contribution to the headline inflation would account for 1.7 p.p. in the period January – May 2022 instead of 0.7 p.p., ie headline inflation would be 10.1% instead of 9.1%. This is only the direct effect thereof, there are also indirect effects, by avoiding the ensuing stronger price rising trend.
Furthermore, reduction of the VAT rate from 5% to 0% on commodities (flour, bread, oil, meat, cheese, milk, eggs, etc.) led to slowing down the inflation growth rate, given that food accounts for the most in the Consumer Price Index. As per the calculations, the reduction of VAT on commodities provided for reducing the headline inflation rate by 1.5 p.p., i.e. in April, the annual inflation rate accounted for 10.5% rather than 12%. Such similar effect was recorded in May 2022 as well, i.e. VAT reduction contributed to reducing the inflation rate by 1.4 p.p. i.e. the annual inflation rate accounted for 13.3% instead of 11.9% in April.
According to these rough calculations, as a result of the fiscal response as regards food and energy products, inflation growth has been cushioned by around a quarter.
New targeted measures under the Supplementary Budget
As per all international institutions, further inflation is forecasted, which is expected to stabilize in 2023, accompanied by slowed down economic growth, expected to return to the pre-pandemic growth trajectory even in 2023/2024. This means that such set of circumstances will last even longer than initially expected. If we add the announcements about global food shortages thereto, resulting from the war in Ukraine – the situation becomes more complex and the uncertainty greater.
This is a strong external shock, affecting almost all economies worldwide. This is a way too big shock to be absorbed by a developing economy. What we can do is act wisely – preserve the stability while protecting those, who are in need of the respective support the most.
By keeping this into account, good fiscal shape is needed to withstand the challenges for a long time, while maintaining fiscal stability. Hence, targeted measures must be put into place, when borrowing on the financial markets is already becoming more costly and any foregone budget revenues will entail borrowing at higher interest paid by the current and the future generations.
Under the Supplementary Budget, we keep adopting measures aimed at providing support to the citizens and the companies. Reserve assets have been allocated for new anti-crisis measures, as well as additional funds as support for farmers, aimed at increasing the domestic yields, thus mitigating the effects of the high prices of imported food. Additional funds have also been allocated for the vulnerable categories of citizens, as well as for increasing the pensions of retirees. All these are targeted measures, since in addition to the support for overcoming the crisis, preserving the macroeconomic stability, is of vital importance as well. Only a stable economy can produce strong and sustainable economic growth.
This should be the end of this column given the limited space allotment for its writing. However, I still need to pay attention to the following:
Coordination between fiscal and monetary policy to combat inflation and avoid stagflation
I could not finish this column covering the topic of inflation without thereby paying attention to the role of coordination between fiscal and monetary policy. Economists generally agree that inflation is a monetary phenomenon. If read “blindly”, the monetary authority should raise interest rates at once, thus reducing the demand for money and liquidity in the economy, which according to monetarists, should also reduce inflation. However, although the macroeconomists will agree that this is the case, they will also point out that the economic and social costs may be too high.
Amidst such circumstances, which resemble the 1970s, we must not allow for the stagflation to strike back again. Inflation triggered primarily by the supply cannot be addressed by only having instruments aimed at reducing the demand, in place. Coordination between fiscal and monetary policy is needed in response to these phenomena in the economy.
Thereby, in order to respond efficiently through measures and policies, accurate diagnostics is needed therefor. For instance, in case of a high fever, we visit our physician, whereby, the first thing the physician does is measuring our body temperature, accompanied by brief medical history and a laboratory test. Based on the results, he prescribes appropriate medical therapy, or if the results show more serious complications, he refers us to the respective doctor specialist. Accordingly, I would end this column by addressing the fiscal and monetary policy. In this respect, having a professional and coordinate approach is the most appropriate solution for overcoming this crisis with less consequences and improved prospects for recovery and growth sustainability.
In the medium and long term, the economy needs to be restructured, by placing the focus on green transition (energy independence and efficiency), digitalization, infrastructure connectivity, enhanced human capital and good governance (rule of law and fight against corruption), thus also contributing to improved business climate and boosted competitiveness of our economy.
Fatmir Besimi, Minister of Finance,