When excessive monetary growth becomes a problem: Why Egypt’s inflation remains an issue

(Photo courtesy of emi moriya/Flickr)

Maintaining a low and stable inflation rate is a primary objective of central banks and governments around the world; yet, it is never an easy task due to many factors that can derail it.

A high and volatile inflation rate is bad news for the countries’ economic health; it directly hits consumers’ pockets, decreases the country’s business competitiveness and entails drastic changes in the distribution of wealth and real income. Furthermore, evidence from many advanced and emerging economies show that a high-inflation environment negatively affects the development of financial markets, and may cause resource misallocation with a dire impact on long-term growth.

In the case of Egypt, and despite the recent pickup in growth, inflation remains a major vulnerability and a threat to the desired long-term prosperity. Egypt has been ranked 15th in the International Monetary Fund’s (IMF) list of counties with highest inflation rates in April 2019, after hitting 14%.

The consumer price hikes resulting from the liberalization of fuel prices, coupled with the devaluation of the Egyptian pound, are believed to be the main reasons why inflation remains drastically high; however, there are still other factors that cannot be disregarded when looking at the bigger picture.

A recent paper entitled “Inflation Dynamics in Egypt: Structural Determinants versus Transitory Shocks” examines the role of excessive monetary growth and relative price variability (RPV) in keeping inflation growing at such a pace. The paper, which is published by the Egyptian Center for Economic Studies (ECES),is written by assistant professor of economics at the American University in Cairo (AUC) Diaa Noureldin, together with ECES researchers Nadine Abdelraouf and Hoda El-Abbadi.

Inflation and price-system stability
High variability in relative prices occurs when inflation rates in the prices of different commodity groups show a high degree of dispersion, which implies large changes in the structure of relative prices in the economy. The paper argues that high RPV in the case of Egypt is closely associated with the rising rates of inflation. The paper suggests that RPV is caused by the historical prevalence of state-fixed prices, and the ongoing price liberalization drive.

It goes on to elaborate how RPV adds noise to the price system, which is the first to fall prey to high and volatile inflationary environments. This happens because the information coming from the market-price system becomes difficult to interpret and thus, both business practitioners and citizens would find it harder to plan long-term commitments. Decision-making processes become a more difficult feat to pull off. This ultimately reduces the efficiency of the economy and makes it less competitive.

Money supply as an “inflationary factor”
Excessive monetary growth is another contributing factor to the general inflationary pressures, the paper argues, attributing its prevalence to a monetary policy framework that is accommodative of the expansionary fiscal stance Egypt is currently witnessing. With signs of fiscal dominance, coupled with ambitious growth targets, there are certainly incentives to create surprise inflation to achieve short-term economic gains.

According to the research, Egypt has witnessed the highest excess money growth rate compared to more than 80 countries between 2011 and 2017, pointing out that the government’s budget deficit is closely linked to the recent significant increase in the rate of money supply growth.

Policy recommendations
Crucial to addressing these two critical issues is to introduce a full-fledged plan that is geared towards lowering inflation rates to avoid its negative consequences, the researchers recommend.

“Egypt needs a comprehensive plan for price liberalization as opposed to the historically-adopted piecemeal approach,” the paper states. In order to tackle that, a study of the optimal sequencing of price hikes should be conducted. Previous research has shown that it may be less inflationary if the prices of administered goods increase at rates slightly above the rate of inflation and in small  increments, rather than large, sudden price jumps.

Furthermore, an introduction of fiscal rules is needed to reduce fiscal dominance and improve fiscal sustainability.“Fiscal rules are part and parcel of an overall institutional setup that is needed to rid the system of fiscal dominance, enhance the independence of the central bank, and improve long-run inflation outcomes,” according to the authors. Additionally, the establishment of an independent body to monitor fiscal operations and public finances could help.

In the end, the research recommends that with the floatation of the currency, the central bank should enhance its communication with the public to explain how the new monetary policy regime of inflation targeting is to be operationalized.

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