Wednesday, 23 July 2014

Egypt faces the risk of stagflation

Egypt cut energy subsidies and faces the unenviable prospect of depressed output and high inflation.

On 5 July 2014, the government of Egypt reduced its subsidies to fuel and electricity leading to a price hike in these products. The government has also announced its intention to remove subsidies completely within the next three to five years. This comes among a set of other measures aiming at reducing the large budget deficit which is becoming harder to finance. While the motivation behind reducing subsidies is understandable, its likely outcome is stagflation—a period of stagnant economic activity and high inflation.

The impact on activity is straightforward. Higher energy prices mean that people have less of their income available to spend on other items. The resulting fall in demand leads to lower output and higher unemployment.

The effect of higher energy prices on inflation however is more multi-layered. First, fuel and electricity are included in the basket of goods and services from which inflation is calculated, so their higher prices directly result in higher inflation. There is also a second round effect as higher energy prices imply a higher cost of production in transportation and industry, which is likely to be transmitted into higher prices for final goods as producers try to maintain their profit margins. This leads to a further rise in inflation.

There is, in addition, a third round effect: If the higher rate of inflation is expected to persist into the future, workers will demand a pay rise by an amount equal to expected inflation to keep their real incomes from falling. Higher wages mean a higher cost of production which in turn leads to the higher prices initially feared by workers as their expectations become self-fulfilling.

While the first and second round effects on inflation are inevitable, the third one is not. If people expect the price increase to be a one-off event, then it will not pass through to higher wages and prices and inflation will quickly fall. But if they do not expect inflation to reverse, then this will lead to wages and prices chasing one another resulting in runaway inflation. Getting one outcome or the other depends on people’s expectations about the future path of inflation and how serious policymakers are about bringing it down.

Which brings us to the recent move by the Central Bank of Egypt (CBE) to raise interest rates on 17 July.  The CBE is clear in its statement that the upward revision to energy prices with its direct and indirect impact on inflation was behind its decision. The CBE raised interest rates in order to “anchor inflation expectations and hence limit a generalised price increase, which is detrimental to the economy over the medium-term.”

Raising interest rates should encourage saving and reduce consumption and investments, hence contain inflation. But a by-product of that policy is an even more depressed output and higher unemployment. This is a price the CBE seems willing to pay to keep a lid on inflation. Whether the CBE’s action and tools would be enough to achieve its aim is something to be seen and observed.

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