TWN Info Service on Finance and Development (July08/03)
9 July 2008
Third World Network

Development: Inflation complicates policies as global economy worsens
Published in SUNS #6512 dated 8 July 2008

Geneva, 7 July (Martin Khor) -- Those who had harboured some hopes that the global financial crisis is over and that the world economy would suffer a mere hiccup had these hopes dashed last week.

The financial problems besetting banks and investment institutions are still expressing themselves with no end in sight. Added to this is a decline of stock markets to official "bear" status. The real economy of jobs and growth is being hit harder.

And on top of all these is the rise of inflation, spurred by the oil price which has hit a high of $145 per barrel, and the onward march of food prices.

The inflation factor affects ordinary people more widely than anything else, as the poor spend more of their income than the well-to-do.

Inflation is also most inconvenient to policy makers, as it deprives them of the ability to use a powerful weapon (changes in interest rates) to counter the other two problems - recession and financial market chaos. Lower interest rates make it cheaper for borrowers to service their loans, consumers to spend and companies to invest.

The US Federal Reserve has been lowering interest rates in many steps to boost the economy. Each time the interest rate was cut by the US Federal Reserve, this would be treated as good news, and the stock market in the US and elsewhere would rise, at least for a few days, before more bad news about a bank in trouble or more job losses led to more market decline.

But the lowering of interest rates also had adverse effects. It had fuelled the credit boom and the price bubbles in houses and equities, that had been a major part of the build up to the crisis.

It also helped spur on speculators in search of higher yield to find more lucrative profits in the oil and commodity markets, which in turn contributed to the recent fast rise in oil and food prices.

Now, with interest rates already so low, there is only a little more of lowering that the US Fed Reserve can do. But even that may not be possible. This is because inflation is once again taking over as a priority problem, and the usual way to fight inflation is to raise the interest rate.

Last Thursday, the European Central Bank raised the main interest rate by 0.25% to 4.25%, the highest level in seven years. This was a few days after data showed European inflation had hit 4%, the highest since the euro was launched in 1999.

Up to a few weeks ago, there was expectation that as recession deepens, governments would counter this by reducing interest rates. Now they are constrained from doing this because of inflation. And instead we can expect interest rates to go up to keep in step with the rising prices.

This puts policy makers in a bind, because a rise in interest rates is about the worst thing that can happen during a recession, as it dampens consumer spending and makes it more costly to repay loans and finance new investments, thus adding to the gloom.

The signs of recession are coming in fast. Last week's news included the loss of another 62,000 jobs in the US in June, with wages stagnating. Britain's economy is also sinking, with the price of houses falling for 8 months (in June, to 6% below a year ago on average), and the big retail chain Marks & Spencer announcing a sharp drop in sales.

The series of bad news hit the stock markets last week. The US had its worst month in June since 2002 and the stock indices had fallen by more than 20% off its peak, thus meeting the definition of a "bear market."

On Friday, "UK and equities shuddered to their lowest levels since 2005, a bleak end to a torrid week as record oil prices fuelled inflation fears and sent investors fleeing to safety," in the colourful words of the Financial Times.

The effects on developing countries have become serious. The value of stock markets in emerging markets fell by 10% in June, contributing most to a US$3 trillion decline in the value of global stock markets in that month.

It was also reported that a quarter of countries in the world now have double-digit inflation, all of them developing countries.

With all the negative news, it is easy to conclude that the economic woes that began with the sub-prime mortgage crisis in the United States is far from over. Instead, the problems have migrated from the finance and housing sectors to other areas (such as the retail trade) while inflation is now rivalling recession.

It is the most complex and difficult economic crisis the world has seen in decades, and possibly since the Great Depression, according to a growing number of well known analysts. +