Tough Medicine Needed to Curb Inflation
- By Martin Gilman
- Feb. 13 2008 00:00
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A relapse of a disease is often more problematic than the original illness. This is the case with inflation in Russia.
It took until 2006 to finally get inflation down to a single-digit -- 9 percent. The long struggle to reduce the inflationary fever finally seemed to be won. The government optimistically projected that inflation would decrease to 7 percent to 8 percent in 2007 and to converge with international levels by 2010.
Because the authorities refrained from the use of harsh medicine, the reduction in inflation was more gradual than many preferred. While fiscal policy was admirably tight when Finance Minister Alexei Kudrin consistently applied a regime of fiscal surpluses that insulated the economy from the full liquidity effects of ever-higher oil prices, the Central Bank maintained a loose monetary policy with interest rates negative in inflation-adjusted terms. But Central Bank head Sergei Ignatyev had little choice if the ruble exchange rate was to be managed in line with the U.S. dollar.
The medicine seemed to work without dampening the performance of the country's formidable economic machine. Real gross domestic product rose from 6.4 percent in 2005 to 7.4 percent in 2006 and to a preliminary 8.1 percent last year. Meanwhile, inflation, which had been as high as 20 percent as recently as 2000, continued to fall into the early months of 2007. But it reached its low point of 7.5 percent year-on-year in March.
That's when the relapse began. Inflation reaccelerated, reaching almost 12 percent for 2007 as a whole, and the momentum continues unabated. The fever is raging. Already in January, inflation rose further to 12.6 percent year-on-year, and it seems to be heading toward 15 percent in the months ahead. Kudrin, who has been appointed the head of a government task force to urgently rein in inflation, optimistically hopes to achieve 8.5 percent this year, but no one in the private sector believes that he will come anywhere close.
Like all relapses, this development is discouraging. It saps the patience of the population that bears the brunt of inflation and pushes the government to take desperate actions in an attempt to demonstrate its resolve to tame the disease. It would seem that almost whatever the authorities try to do now, the fever is bound to get worse in the months ahead.
It appears that Russia's inflation problem is part of a global epidemic. In China, inflation accelerated last year to an 11-year high of 4.8 percent. In the wake of the worst snowfall China has faced in decades -- which affected power supplies, closed factories, and disrupted transport -- it looks like January's inflation will be more than 7 percent. India's inflation unexpectedly accelerated in recent months and is expected to reach a 4 percent annual rate, fueled by food prices. Sharply higher food prices also pushed Brazilian inflation up to 4.5 percent in 2007, ending a five-year period of disinflation. And Eurozone inflation surged to a 14-year high of 3.2 percent last month.
In the United States, concerns over inflation are tempered by an even more overwhelming preoccupation with what could be the most severe recession in at least a generation. Indeed, the Federal Reserve, after its last meeting on Jan. 30, when it again reduced its lending rate, this time to 3 percent, did not even mention inflation as a concern, even though the price level rose last year by 4.1 percent -- the highest rate in 17 years.
Governments around the world are responding, each in its own way, to the spreading disease that they had so painfully brought under control in the last few decades of the 20th century.
For instance, price controls are being used, to different degrees, to control inflation in Asia, South America and Africa. It remains to be seen if these controls are as efficient as macro policy at curbing inflation, or if they simply distort market prices -- but, as in Russia, where "voluntary" controls are being tried, many countries find it hard to remove price controls given the hardships and threats to social stability caused by rising food prices. Some countries have canceled plans to scale back food subsidies.
In Russia, too, the government and Central Bank are urgently trying to devise a strategy to beat the inflation beast once and for all. Kudrin's plan contains some sensible efforts to loosen structural rigidities, along with some less than helpful proposals. In recent days, the Central Bank has sought to tighten credit policy through administrative measures, but liquidity growth remains largely outside of its control because of the exchange rate policy.
The problem for Russia, and some other countries, is that there are no easy options.
Of course, Russia has some special characteristics that make the disease somewhat harder to control than elsewhere. For one thing, the starting level of inflation was already high. High oil prices have fed a mammoth external current-account surplus that stoked internal ruble liquidity via the managed-exchange rate. Favorable economic prospects added to the pressure by encouraging net capital inflows, which contributed even more to liquidity than could be absorbed, even by an economy that grew by 30 percent in nominal terms last year alone. And, of course, the widely publicized Central Bank prognoses of an appreciating ruble in the first part of last year just added to pressure by offering speculators a one-way bet.
Before despairing, it might be useful to think about the global aspects of the problem. The world economy -- other than equity markets perhaps -- is demonstrating divergent developments. Although growth rates may inch down in 2008, domestic demand is fueling high rates of economic growth in China, Russia, India, Brazil and other countries that are not overly dependent on export markets in the United States. As a result, the demand for commodities, especially energy, remains high, and this is putting a floor under any cyclical price decline.
Meanwhile, the United States is probably in a recession already, and Japan and Western Europe are teetering on the brink.
The problem for Russia is that U.S. authorities are reacting as if they are facing a deep and even dangerous recession. Perhaps they are, but in an effort to mitigate the downside risks, they are flooding the world with liquidity. From a U.S. perspective, this may make sense to offset the perceived tightening of credit criteria and rising risk aversion among banks, but for the rest of the world, which uses the dollar as its main reserve currency, this only stokes the flames of inflation. It does so because many countries from Russia to China to the Middle East and Latin America have generally found it convenient to anchor their own currencies to the dollar's credibility and stability. They were hoping that the hard-won, anti-inflationary credentials of the Federal Reserve would rub off on them.
Now the situation has become perverse. Instead of helping to cure the patient, this countercyclical policy -- from Russia's point of view -- just exacerbates an already persistent Russian mutation of the disease. As survivors of the 1998 Russian crisis, perhaps Kudrin and Ignatyev could provide their U.S. counterparts with the same words of wisdom that Washington gave to them 10 years ago: Every country must live within its means.
Martin Gilman, a former senior representative of the IMF in Russia, is a professor at the Higher School of Economics in Moscow.