Why copy the Federal Reserve?

Yusuf Mansur
Yusuf Mansur is CEO of the Envision Consulting Group and former minister of state for economic affairs. (File photo: Jordan News)
With a recession becoming almost a reality in Europe and the US, a legitimate question to ask is whether the economy in Jordan will soon face stagflation (inflation coupled with unemployment). اضافة اعلان

The Central Bank of Jordan (CBJ) recently increased the interest rates on all its instruments to counter, according to published statements, the impact of an otherwise imminent inflation. Within hours of the CBJ's decision, private banks in Jordan raised the interest rates on loans. The merits and demerits of the inflation-unemployment vortex are hardly debated in Jordanian public fora.

The view that inflation causes as much misery as unemployment is flawed and has recently been proven so. Arthur Okun, the renowned economist and Noble Laureate, believed that inflation and unemployment created the same levels of misery; hence, he created the “Misery Index” in the 1970s, which is the sum of the unemployment and inflation rates.

This view was challenged in 2013 by the work of David G. Blanchflower, of Dartmouth College, and three of his colleagues. The finding based on surveys is that while inflation is bad, it is nowhere as bad as unemployment, with the latter being much worse. Therefore, current economic thinking is that unemployment is a worse evil than inflation.

Before COVID-19, the world economies were facing deflation, not inflation. The same was true for Jordan. Sector lockdowns, disrupted global supply chains, persistent reduction in labor supply in advanced economies, recent closure of major economic hubs, such as Shanghai, the new cold war between the US and China, sharp energy price spikes, and the recent Russia-Ukraine war are all fueling inflation.

In addition, countries like the UK, US, Germany, among others, have pumped massive liquidity into their economies to sustain businesses during the pandemic and reduce the negative impact on employer and employee, which created a fertile ground for high inflation rates.

In the US and Europe, the drive is to increase the interest rate in order to make it more expensive to borrow and spend, which in turn would reduce the inflation rate. Given that the interest rates in these economies have been close to zero for a long time, and given the low unemployment rates they enjoy, such a policy seems to make sense. However, even in these economies it is understood that fighting inflation comes at a cost.

The experience of Paul Volker, the Federal Reserve chairman in the early 1980s, illustrates a policy taken to the extreme. Faced with a runaway inflation, he raised interest rates to historic highs (from 11 percent to a record 20 percent) by late 1980; the price of conquering a double-digit inflation was recession.

In Jordan, the monetary policy was not as expansionary as in the developed economies, and the fiscal policy, ever strapped by an enduring fiscal inflexibility (budget deficit and debt), could not do much either.

Inflation comes to Jordan thus not from an excessive money supply but from the negative supply shocks that rocked production worldwide, which affected the cost of imports, which, at JD13,822 million in the first 11 months of 2021, was two and a half times the national exports.

Furthermore, unemployment stood at 24 percent (almost 50 percent among the youth), and growth in 2021 was 2.2 percent in constant prices. Nevertheless, inflation, as measured by the consumer price index, in April 2022 was not that significant: 2.47 percent. 

Contrary to widely circulating assertions, Jordan is not facing an inflation rate that warrants such drastic steps as raising the interest rate by 0.5 percent. Even if this is a precautionary step, prices did not rise because of an oversupply of money but because of the rise in the price of imports. So, the rise in interest rate will not curb the inflation rate.

Furthermore, the claim that the economy has recovered to pre-pandemic levels hides the fact that even if true, the pre-pandemic rates were those of a long-drawn recession; they are not desirable at all.

Most likely, increasing the interest rates would further weaken the economy and not strengthen it, as it will lead to higher cost of money, which will make investing and consuming less attractive.

The truth of the matter is that historically, the CBJ raises and lowers its interest rates in complete tandem with those of the Federal Reserve. There is no new policy here. The reason for such steadfastness in copying the Feds is the myth that maintaining a vigorous margin between the rates on the US dollar and the Jordanian dinar stops dollarization. But the margin has grown over the past 20 years. Furthermore, and I repeat herein a claim I made 22 years ago, this margin is not supported by an empirical study or studies that prove its “sanctity”.

A simple econometric exercise would easily show that Jordanians hoard dollars when the economic growth is weak and are encouraged to maintain dinar accounts when the economic growth is strong. The higher interest rates on the dinar deposits only work in attracting dinar deposits when the economy performs well. The impact is that of icing on a cake. The margin, however, does not work when times are bad.

The upshot of all this is that we need not fully match the Federal Reserve actions regarding the rate of interest. There is some leeway and it should be used, especially when the economy needs to grow to curb unemployment.

The writer is CEO of the Envision Consulting Group and former minister of state for economic affairs.

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