By Tobias Adrian and Vitor Gaspar Government support was vital to help people and firms survive pandemic lockdowns and support the economic recovery. Where inflation is high and persistent, across-the-board fiscal support is not warranted. Most governments have already dialed back pandemic support, as noted in our October Fiscal Monitor. With many people still struggling, governments should continue to prioritize helping the most vulnerable to cope with soaring food and energy bills and cover other costs—but governments should also avoid adding to aggregate demand that risks dialing up inflation. In many advanced and emerging economies, fiscal restraint can lower inflation while reducing debt. Fiscal consolidation, limiting debt Central banks are raising interest rates to dampen demand and contain inflation, which in many countries is at its highest levels since the 1980s. Because rapid price gains are costly to society and detrimental to stable economic growth, monetary policy must act decisively. While monetary policy has the tools to subdue inflation, fiscal policy can put the economy on a sounder long-term footing through investment in infrastructure, health care, and education; fair distribution of incomes and opportunities through an equitable tax and transfer system; and provision of basic public services. The overall fiscal balance, however, affects the demand for goods and services, and inflationary pressures. A smaller deficit cools aggregate demand and inflation, so the central bank doesn’t need to raise rates as much. Moreover, with global financial conditions constraining budgets, and public debt ratios above pre-pandemic levels, reducing deficits also addresses debt vulnerabilities. Conversely, fiscal stimulus in the current high inflation environment would force central banks to slam on the brakes harder to curb inflation. Amid elevated public and private sector debt, this may raise risks for the financial system, as our Global Financial Stability Report described in October. Demonstrating alignment Against that backdrop, policymakers have a responsibility to provide strong protections to those in need, while paring back elsewhere or raising additional revenues to reduce the overall deficit. Fiscal responsibility—or even consolidation where needed—demonstrates that policymakers are aligned against inflation. When fiscal adjustment is sustained, ideally through a medium-term fiscal framework that sketches the direction of policy over the next few years, it also addresses looming pressures on debt sustainability. These include aging populations in most advanced and several emerging economies, and the need to rebuild buffers that can be deployed in future crises or economic downturns.  In our research, we use a stylized two country model (where the “home economy” may be the US or a group of advanced economies). We study two different approaches to curb inflation. The first relies exclusively on monetary tightening to cool the overheating economy, whereas the second involves fiscal consolidation. Both are constructed to have similar effects on economic growth, and each is effective in reducing inflation. Under the first, higher interest rates and the weaker growth contribute to rising public debt. Meanwhile, the currency appreciates as higher yields attract investors. Under the second approach, fiscal tightening cools demand without the need for interest rates to rise, so the real exchange rate depreciates. And with lower debt-service costs and smaller primary deficits, public debt declines. The real exchange-rate appreciation under tighter monetary policy implies that inflation falls a bit more, but this difference would diminish if more countries pursued these policies. Faced with high food and energy prices, governments can improve their fiscal position by moving from broad-based support to assisting the most vulnerable—ideally, through targeted cash transfers. Because supply shocks are long-lasting, attempts to limit price increases through price controls, subsidies, or tax cuts will be costly to the budget and ultimately not be effective. Price signals are critical to promote energy conservation and encourage private investment in renewables. The desirable fiscal stance and measures underpinning it will depend on country-specific circumstances, including current inflation rates and longer-term considerations such as debt levels and developmental needs. In most countries, higher inflation strengthens the case for fiscal restraint, calling for raising revenue or prioritizing spending that preserves social protection and growth-enhancing investments in human or physical capital. International dimensions In the United States, the early-1980s disinflation under Federal Reserve Chairman Paul Volcker exemplified the challenges of controlling inflation. Inflation had become entrenched at high levels, and fiscal policy was expansionary. The Fed had to raise rates sharply to rein in inflation, causing a collapse in housing investment and historically large appreciation of the dollar. Manufacturing was hard hit, leading to calls for trade protectionism. That historical episode is relevant for many countries facing similar challenges today. A more balanced removal of policy stimulus, including fiscal restraint, can reduce the risk that some parts of the economy—especially those most sensitive to interest rates—experience disproportionate effects, or that large swings in the currency heighten trade tensions. This would also reduce risk globally. Less abrupt interest rate hikes would imply a more gradual tightening of financial conditions and mitigate financial stability risks. This would tend to limit adverse spillovers to emerging market economies and reduce the risk of sovereign debt distress. Avoiding a sharp appreciation of the US dollar or other major currencies would also lessen pressures on emerging markets that borrow in those currencies. While many central banks are tightening policy in response to the large and persistent rise in global inflation, the policy mix matters. Fiscal restraint will reduce the cost of bringing inflation back to target in a timely way, compared with the alternative of leaving monetary policy alone to act.
(Photo: Lucadp/AdobeStock) | By Habtamu Fuje, Saad Quayyum, and Tebo Molosiwa The collapse of the world’s third largest crypto exchange FTX, and subsequent plunge in the prices of Bitcoin, Ethereum, and other major crypto assets, is prompting renewed calls for greater consumer protection and regulation of the crypto industry. Regulating a highly volatile and decentralized system remains a challenge for most governments, requiring a balance between minimizing risk and maximizing innovation. Only one-quarter of countries in sub-Saharan Africa formally regulate crypto. However, as our Chart of the Week shows, two-thirds have implemented some restrictions and six countries—Cameroon, Ethiopia, Lesotho, Sierra Leone, Tanzania, and the Republic of Congo—have banned crypto. Zimbabwe has ordered all banks to stop processing transactions and Liberia directed a local crypto startup to cease operations (implicit bans).  Africa is one of the fastest-growing crypto markets in the world, according to Chainalysis, but remains the smallest, with crypto transactions peaking at $20 billion per month in mid-2021. Kenya, Nigeria, and South Africa have the highest number of users in the region. Many people use crypto assets for commercial payments, but their volatility makes them unsuitable as a store of value. Policymakers are also worried that cryptocurrencies can be used to transfer funds illegally out of the region and to circumvent local rules to prevent capital outflows. Widespread use of crypto could also undermine the effectiveness of monetary policy, creating risks for financial and macroeconomic stability. The risks are that much greater if crypto is adopted as legal tender—as the Central African Republic recently did. If crypto assets are held or accepted by the government as means of payment, it could put public finances at risk. The Central African Republic is the first country in Africa, and the second in the world after El Salvador to designate Bitcoin as a legal tender. The measure has put the country at odds with the Bank of Central African States (BEAC)—the regional central bank that serves the Economic and Monetary Community of Central Africa (CEMAC), which the Central African Republic is a member of—and violates the CEMAC Treaty. BEAC’s banking sector supervisory body—Central Africa's Banking Commission—has banned the use of crypto for financial transactions in the CEMAC region. —This blog is based on the October 2022 Regional Economic Outlook for sub-Saharan Africa
(Photo: IMF Photos) | By Tryggvi Gudmundsson Global economic growth prospects are confronting a unique mix of headwinds, including from Russia’s invasion of Ukraine, interest rate increases to contain inflation, and lingering pandemic effects such as China’s lockdowns and disruptions in supply chains. In turn, our latest World Economic Outlook, released last month, lowered our global growth forecast for next year to 2.7 percent, and we expect countries accounting for more than one third of global output to contract during part of this year or next. Moreover, as we discuss in our latest report prepared for the Group of Twenty, recent high-frequency indicators confirm that the outlook is gloomier. As the Chart of the Week shows, there has been a steady worsening in recent months for purchasing manager indices that are tracking a range of G20 economies. These survey-based measures gauge the momentum of manufacturing and services activity.  As the chart illustrates, readings for a growing share of G20 countries have fallen from expansionary territory earlier this year to levels that signal contraction. That is true for both advanced and emerging market economies, underscoring the slowdown’s global nature. While gross domestic product releases for the third quarter surprised on the upside in some major economies, October PMI releases point to weakness in the fourth quarter, particularly in Europe. In China, intermittent pandemic lockdowns and the struggling real estate sector are contributing to a slowdown that can be seen not only in PMI data but also in investment, industrial production, and retail sales. This will inevitably have a significant impact on other economies due to China’s large role in trade. Despite growing evidence of a global slowdown, policymakers should continue to prioritize containing inflation, which is contributing to a cost-of-living crisis, hurting low-income and vulnerable groups the most. As our G20 report emphasizes, the macroeconomic policy environment is unusually uncertain. However, continued fiscal and monetary tightening is likely needed in many countries to bring down inflation and address debt vulnerabilities—and we do expect further tightening in many G20 economies in the months ahead. Nonetheless, these actions will continue to weigh on economic activity, especially in interest-sensitive sectors such as housing. The challenges that the global economy is facing are immense and weakening economic indicators point to further challenges ahead. However, with careful policy action and joint multilateral efforts, the world can move toward stronger and more inclusive growth. |
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