Keep Your Seatbelt Fastened
By Mohamed El-Erian
August 2, 2008
Mohamed El-Erian offers advice on how the world's economic leaders should navigate an especially challenging policy environment in a Newsweek Forum: "Explaining the Pain: Economic Leaders and Experts Lay Out the Inflation Problem, and How to Fix It,” originally published on August 2.
The global economy, still reeling from the U.S. financial crisis, has entered an even riskier phase on account of inflationary pressures. Inflation is particularly painful when it is driven, as it is now, by price increases on essential products like food and fuel. Governments and companies have to react even if they end up using blunt instruments that initially make the situation worse.
Today's situation is particularly complex, as a good part of the recent price rises were driven by these perverse second-round effects. This is evident on both the supply and the demand side where the immediate reactions of many market players to the food and oil price rises aggravated global supply-and-demand imbalances.
For example, rather than increase output in response to higher prices, some food producers imposed export bans in an attempt to safeguard supplies for their domestic populations. In the process, they cut supply to a fragile world market in which prices were already rising. In the energy market, some companies (including airlines) rushed to secure supplies by purchasing future contracts that, ironically, they deemed too expensive to buy at lower prices. That too fosters price increases.
This perverse dynamic is starting to reverse itself. Additional supply is beginning to hit the food and energy markets as other producers seek to capitalize on the significant price jumps. Also, part of the demand for these products is being destroyed as a growing number of consumers get priced out of markets.
But this reversal is not happening fast enough, especially when it comes to sheltering the segments hardest hit by inflation, such as the poor. This raises the pressure on policymakers to do something, if only to show that they care.
Certainly prompt policy action is needed, to moderate expectations of future price increases and prevent a protracted bout of inflation that is harmful to the well being of societies. And policymakers have reacted, placing heavy if not exclusive emphasis on monetary actions.
In emerging economies, central bankers have been raising interest rates and tightening credit growth, combating inflation by sacrificing some of today's growth. In industrial countries, central banks have increased their anti-inflationary rhetoric, causing markets to raise interest rates.
In normal times, the emphasis on monetary policy would be necessary and warranted. But conditions are far from normal in today's global economy. Pending progress in healing an injured financial system, especially in the U.S., such reactions are simply too blunt. Indeed, with the "transmission mechanism" largely inoperative, national authorities may legitimately pursue some well-intentioned policy objectives yet end up creating significant problems elsewhere. So, what should we expect in the coming weeks and months? I am afraid that the answer is more collateral damage to the global economy. This will occur through two distinct, but reinforcing channels.
First, tighter financial conditions, especially higher mortgage rates, will further undermine a U.S. housing market that is already collapsing under the weight of overvaluation, excessive inventories and growing foreclosures. The recent decision by the U.S. Congress to extend emergency assistance to mortgage holders and behemoth lenders (such as Freddie Mac and Fannie Mae) will only act as a short-term Band-Aid. In particular, it will prove inadequate to offset the headwinds facing American consumers who, for a number of years, constituted the "main" engine driving the global economy but are now struggling to overcome the combined impact of higher unemployment, declining living standards, and lower credit availability.
Second, growth in emerging economies will also decline as policymakers there realign their domestic priorities. For the global economy, this means slowing the "other" engines that, particularly in the past year, have accounted for a growing share of the increase in world GDP, thereby effectively compensating for the more sluggish U.S. economy.
Where does this leave us? The bottom line is that policymakers have no choice but to react to the food and energy price spikes. But in relying overwhelmingly on tighter monetary policy, and in failing to aggressively pursue enhanced production and distribution channels for food and energy, they risk weakening global demand too much, thereby being potentially forced into a sudden reversal. The rest of us should keep our seat belts fastened as the global economy continues to navigate an even bumpier phase, as weakening growth impulses aggravate the impact of the credit crunch.
El-Erian is co-chief executive officer and co-chief investment officer of PIMCO, and author of "When Markets Collide: Investment Strategies for the Age of Global Economic Change" (McGraw Hill).
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