New CEPR Policy Insight - From low to high inflation: Implications for emerging market and developing economies

Wednesday, March 30, 2022

Global inflation has risen over the past year from less than 2% to over 6%, the highest level since 2008. Rising inflationary pressures and a surge in commodity prices as a result of the war in Ukraine will likely raise inflation further in 2022. This persistence of above-target inflation creates a historic monetary policy challenge, especially for emerging market and developing economies (EMDEs), whose high debt and weak fiscal positions make them vulnerable to tightening financial conditions. 

A new CEPR Policy Insight by Jongrim Ha, M. Ayhan Kose, and Franziska Ohnsorge addresses the key implications for EMDEs in light of these developments, and emphasizes the importance of calibrating policies with macroeconomic stability in mind, communicating policies clearly, and preserving and building credibility.

Jongrim Ha (World Bank), M. Ayhan Kose (World Bank, Brookings Institution, CAMA and CEPR), and Franziska Ohnsorge (World Bank, CAMA and CEPR)

Available for download here >>>

While global inflation initially declined at the start of the pandemic, the rebound in 2021 and early 2022 has been faster and steeper than forecasters expected. Nevertheless, global inflation had been expected to peak around the middle of this year and then decline gradually towards target levels through 2023. However, the surge in commodity prices and more persistent supply-chain disruptions since the invasion of Ukraine has led to a reassessment of the likely evolution of global inflation over the near term. Global inflation may stay elevated for a prolonged period or even increase further, leaving inflation above the target range for many countries (see Figure). As elevated inflation levels persist, the risk grows that expectations of higher inflation become baked into wage- and price-setting behaviour.

Figure: Short-term global inflation expectations

Note: Lines show the median one-year-ahead headline CPI inflation expectations for 32 advanced economies and 51 EMDEs derived from February 2022 Consensus Economics surveys.

As central banks in advanced economies respond to increased inflationary pressures with a gradual reduction of the unconventional support introduced during the pandemic and (in some) raising policy interest rates, the path is less clear for EMDEs. As this Policy Insight shows, raising policy rates in these economies could compound the increase in global financing costs that will likely accompany tightening monetary policy in advanced economies – before the recovery from the pandemic in EMDEs is complete and in the presence of multi-decade high levels of debt of all types. The authors argue that a faster-than-expected monetary policy tightening cycle could further exacerbate already heightened macroeconomic vulnerabilities in EMDEs and trigger an even sharper slowdown in growth. Indeed, tightening cycles in advanced economies in the past were often associated with financial stress in EMDEs, with severe and long-lasting macroeconomic consequences. 

The monetary policy challenge of fighting inflation is thus significantly more complex for EMDEs than advanced economies, since they need to safeguard their recovery as well as financial stability, while coping with changes in global financial conditions. In the current international environment of heightened uncertainties, this Policy Insight argues that EMDEs need to focus on calibrating their policies with macroeconomic stability in mind, communicating their policies clearly, and preserving and building their credibility

What can EMDE policymakers do?

  • For monetary policy, calibrating policy levers to get ahead of inflation without stifling recovery will be key. For EMDEs, communicating monetary policy decisions clearly (with financial markets but also with households and firms), leveraging credible monetary frameworks and safeguarding central bank independence will also be critical to manage the cycle. 
  • On the financial side, policymakers can rebuild reserve buffers and realign prudential policy to prepare for potential financial stress. Banking system exposures to exchange rate risk and rollover risk need to be monitored carefully and, if necessary, contained through macro- and micro-prudential policies. Credit quality and nonperforming loans need to be reported transparently such that prompt corrective action can be taken. Banks’ capital and liquidity buffers need to be sufficiently large to be able to absorb shocks. If deployed appropriately, reserve buffers can help stem temporary exchange rate pressures.
  • The pace and magnitude of withdrawal of fiscal support must be finely calibrated and closely aligned with credible medium-term fiscal plans. Policymakers will need to address investor concerns about long-run debt sustainability by strengthening fiscal frameworks, enhancing debt transparency, upgrading debt management functions, and improving the revenue and expenditure sides of the government balance sheet. 
  • To address volatility in food prices, EMDE policymakers need to strengthen social safety nets and enhance the resilience of food systems, while refraining from counterproductive price control measures. Price controls tend to distort markets and have adverse consequences for growth and poverty reduction, which often prove difficult to roll back after a crisis.
  • Mounting inflation and fiscal pressures could heighten tensions between the multiple objectives of low-income country central banks. Broader policy efforts aimed at strengthening fiscal and monetary policy frameworks, and improving debt management, are required in these economies to safeguard price stability.

*The findings, interpretations, and conclusions expressed in this Policy Insight are entirely those of the authors; they do not necessarily represent the views of the World Bank and its affiliated organisations. 

You can also read a Vox Column here >>>.

Find a full list of CEPR's Policy Insights here >>>.