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.

A bloody June in Iraq

Iraqis left physically unharmed by violence may still have an economic price to pay.

Iraq witnessed its bloodiest month in June since the height of its civil war in the summer of 2007. Preliminary data show that almost 2,000 civilians have died as violence gripped the country. The figure would rise significantly if casualties from the Iraqi security forces were also included. Not only does increased violence threaten the physical safety of Iraqis, it also adversely impacts the economic well-being of those fortunate enough to survive unharmed.

Data on casualties from violence in Iraq come from two main sources. The United Nations Assistance Mission for Iraq (UNAMI) publishes statistics on civilian and security forces casualties based on witness reports as well as evidence from civil leaders, government officials, international organisation, media reports and the UNAMI own network in Iraq. The figures released by UNAMI show that 1,531 civilians and 886 members of the Iraqi Security Forces were killed in June. These numbers exclude deaths in the Anbar province, where the UNAMI estimates further 244 civilian deaths. The figures make June comfortably the bloodiest month since UNAMI started publishing its statistics in January 2008.

The second source is Iraq Body Count, a project to record civilian casualties in Iraq since 2003 based mainly on verifiable media reports. Its preliminary estimate for civilian casualties in June stands at 1,934—the highest number since August 2007, or the heydays of the civil war. The data also show that 2014 is on track to become the most violent year outside 2005-7.

Unsurprisingly, increased level of violence tends to take its toll on economic activity. In recent years, higher levels of violence in Iraq were associated with lower economic growth. As the chart below displays, 2007 was the second most violent year and also the year which witnessed the slowest growth rate. In contrast, the relatively peaceful years of 2009-12 saw some of the highest levels of growth. Only 2006 stands out as an outlier with both high levels of violence and a fast-growing economy.

What does that imply about growth in 2014? If the levels of violence seen in the first half of 2014 were to continue into the second half of the year, 2014 would be the most violent year outside the 2005-7 period. Should the impact of violence on the economy be similar to the one witnessed in recent years, then we should expect real GDP growth of 4.4%.

Alternatively, a more tragic scenario in which the elevated levels of violence in June continued for the rest of the year would result in 18.5 thousand civilian deaths, making 2014 the third most violent year after 2006-7, the peak of the civil war. Under this scenario, real GDP would grow by a mere 3.1%. Given that population is also expected to grow by 3.1%, this would imply stagnant economic conditions for the average Iraqi.

So what are the economic costs of increased violence? The International Monetary Fund had recently forecast real GDP growth of 5.9% in 2014, the recent rise in violence would probably shave off 1.5-2.8% from this year’s real GDP—a significant cost for a country still lagging behind in terms of goods and services provided.

It means that Iraqis who were fortunate enough not to lose their lives or get injured during the recent violence may still have an economic price to pay.