Heed the warnings

The International Monetary Fund's October 2022 World Economic Outlook projects contraction in one-third of the world economy this year or next. Persistent and broadening inflation is shaping the slope of the challenges facing the global economy driven primarily by ongoing supply disruptions and uncertainties. No matter what policy a country pursues, cost in some form makes an ugly appearance. Apparently win-win structural reforms come with pains in traction.

Stubborn global inflation

Shocks in 2022 have aggravated not yet healed post-pandemic economic wounds. Rapidly rising food and energy prices are causing serious hardship for poor households everywhere. Broadening well beyond food and energy, global core inflation rose to multi decade highs from an annualised monthly rate of 4.2% at end-2021 to 6.7% in July for the median country, reports the WEO. Inflation in Bangladesh was at an eleven year high in August-September at 9% plus.

Excess demand perpetuated inflation in 2021. Central banks assumed pent up demand was a post-pandemic aberration that would dissipate in a few months in 2021. The intensity of shocks related to clogged supply chains and the war in Ukraine in 2022 soiled the wheels of supply while the expected cooling of demand was not happening soon enough. The pass-through of energy prices, supply chain cost pressure, and tight labour markets, especially in advanced economies, increased core inflation. The WEO finds no evidence of any wage-price spiral or markup increases in the propagation of current inflation.

Overall, international inflation has gained momentum. Commodity prices might start to ease as global demand slows if the supply conditions do not deteriorate. Supply-side factors dominate current food price dynamics. The war in Ukraine amplified pre existing stresses in global commodity markets, driving natural gas prices even higher. Climate change is morphing into extreme heat waves and droughts with direct and immediate impact on agricultural productivity. Restrictions on food exports by several countries and sanctions have added to price pressures.

The global headline consumer price inflation is projected to rise from 4.7% in 2021 to 8.8% in 2022 before receding to 6.5% in 2023 and 4.1% in 2024. The peak is past assumption is reasonable if the underlying economic conditions remain as they are. The disinflation for 2023 is projected in almost all economies, including Bangladesh, but is most pronounced in advanced economies who benefit more than developing economies from greater credibility of policy commitments to tame inflation.

The worst is yet to come

Since 2020, progress in poverty reduction has been slow. The World Bank's nowcasts in their "Correcting Course" (2022) report suggest poverty reduction resumed in 2021 at the anaemic rate prior to the pandemic, stalling further in 2022 as global growth slowed with higher food and energy prices, hurting poor urban households much more than others. Global real GDP modestly contracted by 0.1 percentage point (at a quarterly annualised rate estimated in the October WEO) in the second quarter of 2022. Growth in China, Russia, and the US were negative along with sharp slowdowns in eastern European countries.

An era of global income divergence is gaining ground. A decline in global GDP per capita is not in the WEO forecast. The world economy is projected to grow 3.2% in 2022, with advanced economies growing 2.4% and emerging market and developing economies 3.7%. Global growth in 2023 may slow to 2.7%, with advanced economies growing 1.1% and developing economies 3.7%. A contraction in real GDP lasting for at least two consecutive quarters is likely at some point during 2022–23 in about 43% of economies, constituting more than one-third of world GDP. GDP contracted in the first half of 2022 in the US. A contraction in the second half of 2022 in the euro area is imminent.

The 6% FY23 GDP growth projection for Bangladesh is comparable to the forecast from other international agencies and for Vietnam and India. Nature has not been kind to agriculture this year while gas and electricity shortages show little sign of abating. The increased prices of raw materials and intermediate inputs also have contractionary effects. Domestic demand is likely to be compressed due to historic high inflation. Export demand conditions and the cost of trade financing are getting worse.

Deep uncertainties cloud forecasts. The world might be fragmenting into different spheres of geopolitical influence, limiting global trade, misdirecting capital flows, and increasing volatilities. China's lockdowns may strain global supply chains deeper and longer. Backtracking on the Black Sea grain deal could keep energy and food prices higher for an extended period. A prolonged increase in input costs could prompt firms to pass on higher costs to preserve margins. Extreme weather events or sudden shifts in the state of the Ukraine war, not to speak of unanticipated geopolitical turmoil, and associated sanctions might undermine global food and energy supply, tipping off a livelihood crisis in low-income countries.

What else may go wrong?

The risk of navigational mistakes is naturally elevated in an unknown territory with low visibility. Central banks have rapidly lifted nominal policy rates. As many as 33 of 38 central banks monitored by the Bank for International Settlements have raised interest rates in 2022 (The Economist, October 5 2022). A deteriorating growth outlook with subdued consumer and investor sentiment sits somewhat awkwardly alongside tight labour markets. Employment growth in advanced economies is projected to increase from 1.8% in 2021 to 2.3% in 2022 before falling to 0.2% in 2023.

Not tightening enough may require a more hawkish future stance on interest rates as inflation gets entrenched, raising the loss to output and employment. Overtightening risks sinking many economies with struggling financial markets into prolonged recession. The already injured credibility of central banks could be further undermined if they misjudge yet again the persistence of inflation as reaffirmed on Thursday by 8.2% inflation in the US in September. Monetary policymakers have in fact been engaged in a decades-long process of trial and error. Quantitative tightening is a phenomenon without empirically based priors.

A policy mistake spiralling inflation could presumably be more detrimental than stoking recession by overtightening. The costs of policy errors are not symmetric. The World Bank's "Is a Global Recession Imminent" (September 2022) reports the experience of the 1970s, the policy responses to the 1975 global recession, the subsequent stagflation, and the 1982 global recession to illustrate the risk of allowing inflation to remain elevated for long while growth is weak. The 1982 global recession triggered more than 40 debt crises followed by a decade of lost growth in many developing economies.

Divergences in economic policies could heighten US dollar strength on top of rise in geopolitical tensions. The dollar has appreciated by about 15% in 2022 against the euro, over 10% against the renminbi, 25% against the yen, and 20% against sterling (October 2022 WEO). For the first time since 2002, the USD and Euro had a 1:1 exchange rate. While a blessing to Americans travelling abroad, life has become difficult for other nations and multinational companies with devalued currencies around the world.

Stronger dollar may further stress developing countries. Countries with depreciating currencies and dollar debt constituting a large portion of GDP such as Argentina, Turkey, and Sri Lanka, are living the higher burdens. Further policy tightening in advanced economies may add to borrowing costs on top of energy and food price shocks in vulnerable economies. Their non-financial and financial corporates with unhedged currency exposure are already facing liquidity and solvency tremors.

External resilience could slip. Dollar being the dominant currency for invoicing and settling a majority of global trade transactions, inhibits global trade when it is too strong for too long. Firms have to reduce their spending on crucial imports. Foreign investors tend to pull the funds out to safer destinations. Developing countries have already spent an estimated $379 billion of reserves to defend their currencies this year, almost double the amount of new Special Drawing Rights allocated to them by the IMF in 2021. Bangladesh Bank has spent over $4 billion in the first three and half months of FY23, twice the share of new SDRs it received in 2021 and 53% of the reserves unloaded in all of FY22.

Policy dilemmas and gambles

Conventional wisdom bets on monetary policymakers' resolve to avoid the stop-go cycle for durably reducing inflation. Yielding to pressure to slow the pace of tightening undermines credibility, allows inflation expectations to rise, and necessitates more aggressive and painful policy actions later, akin to losing the baby with the bathwater. At the same time, there is little to believe disinflation through higher interest rates is possible without generating a recession. UNCTAD's Trade and Development Report 2022 characterises policies based on such a belief as "imprudent gamble".

Tighter monetary policy by the advanced economies creates dilemmas for developing countries. Low-interest rates lead to capital outflows and domestic currency depreciation. Tighter monetary policy, on the other hand, derails a fragile domestic economic recovery. The World Bank's "Navigating Multiple Crisis…" (July 2022) report describes it as a "perfect storm that has the potential to undo decades of development gains".

Countries have few options to navigate for now. They have to make difficult choices in the composition of spending, given the need to tighten fiscal stance. Without fiscal contraction elsewhere, and with tight supply, unfunded government spending increases or tax cuts make monetary policy's job harder. The most vulnerable members of society need cover from the impact of higher prices through targeted and temporary transfers. Along with measures to offset any increase in new spending, fiscal policy cannot afford to lose focus on investing in human capital, digitalisation, green energy, and supply chain diversification.

Countries such as Bangladesh cannot take anything for granted. The adequacy of foreign exchange availability comes with getting external deficit down to levels of renewable financing. Prompt and reliable access to reserve currency liquidity provides breathing room for orderly implementation of adjustment policies. Intensifying structural reforms to improve productivity and ease of trading internally and externally would unlock supply constraints. But they don't come easy.

Financial sector transparency and surveillance is no gamble. Analytical and empirical work on the role of the financial sector in propagating economic crisis has won Bernanke, Diamond, and Dybvik a Nobel prize in economics this year. Countries with fragile financial institutions and markets such as Bangladesh need to take some serious notes from their research on why regulation sometimes fails, the gargantuan scale of the consequences and the options for suppressing an impending banking crisis from a global recession.

Zahid Hussain is former lead economist of World Bank Dhaka office