Worries about the recession and global economic crisis, and governments' wish to act resolutely against their effects led most of them to forget another danger - inflation. There is now real concern about an inflationary outbreak and a loss of control at the turning point from recession to growth. Cheap and available money for the financial system boosts short-term demand. It also boosts consumption, but has less impact on long-term investment.
The signs of inflation were seen in the 0.9% rise in the Consumer Price Index (CPI) in June, a rise that was well above expectations of a 0.4-0.5% increase. Inflation is now running at 3% or more, at the upper limit of the government's inflation target and at the higher end of inflation in developed/Western countries. The Bank of Israel has adopted an expansionist monetary policy, including interest rate cuts and intervening in the capital market, which has encouraged demand and diverted resources from savings to immediate consumption. The government has adopted an expansionist fiscal policy of higher deficits and lower taxes, which also encourage demand.
The concern is that the government deficit, which is financed by higher debt, will drive up the long-term interest rate (in contrast to the Bank of Israel interest rate, which is short-term), which will lead to postponement of long-term investment by the private sector.
In other words, there is a process of diverting savings from private investment to the government's coffers. This is liable to hurt manufacturing capacity and the economy's competitiveness in the future. In this context, it is necessary to be alert to the fact that the economic crisis is eroding competitiveness in the economy, by reducing demand from foreign investors and customers, and through the development of manufacturing and technological capabilities in countries with cheap labor.
The debt-financed government deficit means that, in future, a larger part of government spending will go to the pockets of bondholders, as higher interest payments are made at the expense of spending on other budget items. Although the government and the Bank of Israel acted in the past few years of economic growth to reduce Israel's debt burden, it is still relatively higher than in other developed countries.
Raising capital overseas increases inflationary pressure through capital inflows, which increases the domestic money supply and demand by the public sector. The global economy should be wary that the transition from recession to recovery could be accompanied by a sharp rise in the price of commodities, which will lead to higher imported local inflation. It is hard to control this effect in an open economy, and it adds to the inflation risk.
The consequences of an inflationary outbreak are damaging. The first is the erosion of the public's money, since most savings are deposited in unlinked assets. Inflation also erodes earning power and actual salaries. Another consequence is the flight of foreign investors from an inflation-plagued economy, even if the rate is not high, for fear of economic instability and the erosion in the value of investments in real terms.
Inflation diverts investment from non-financial investments to financial investments in an effort to preserve the value of the money and achieve profits by exploiting inflation. Ultimately, the growing signs of inflation are liable to cause an extreme response by monetary policymakers, which could cause shocks in the real economy and delay its recovery. Under these circumstances, there is a need for rapid adaptation to high interest rates, which is hard for individuals and companies to do.
The question is what measures can be taken now to prevent an inflation outbreak?
These measures include reducing the government deficit, in part by making tax cuts more gradual, combined with a government commitment to implement them. At the same time, the increase in government demand should be used to boost the economy's manufacturing competitiveness, create jobs, and improve the economy's competitiveness in the long term (such as by investing in R&D) instead of using the money for transfer payments.
Although transfer payments boost demand, the effect is temporary and short term. As demand rises in the short term, production cannot keep pace (a process that usually happens at the turning point from recession to recovery), resulting in inflation.
The process of diverting demand to long-term investment, which gradually boosts employment and output, results in a much better congruence between rising demand and rising output, and prevents the creation of inflationary pressures and high inflation. This will also prevent the need for extraordinary measures, such as dramatic interest rate hike. Raising the interest rate in response to inflationary pressures could be problematic politically at a time when the economy has not yet emerged from recession.
Shahar Ziv is a senior partner at BDO Ziv Haft and head of the BDO Consulting Group
Published by Globes [online], Israel business news - www.globes-online.com - on July 29, 2009
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