A recent spike in inflation woke up fears that Ukraine can slide to hyperinflation of the early 1990s. Indeed, the government faced a glaring fiscal gap in 2014-2015 and got a tangible fraction of its revenue from seigniorage, which is, printing money. Inflation expectations rose to levels not seen for more than 10 years
By Yuriy
Gorodnichenko
UC Berkeley
Robert Solow, a
Nobel prize winner, suggests that the country can has inflation
because it expects inflation, and expects inflation because it has
it. Once economy happens to be in such high inflation equilibrium, it is
hard to get out from it. Given that Ukraine has had high and volatile inflation
since its independence, it may seem that the situation is hopeless and
forecasting inflation at long horizons is futile. Yet, this is a wrong view.
A recent spike
in inflation woke up fears that Ukraine can slide to hyperinflation of the
early 1990s. Indeed, the government faced a glaring fiscal gap in 2014-2015 and
got a tangible fraction of its revenue from seigniorage, which is,
printing money. Inflation expectations rose to levels not seen for more than 10
years (see Figure 1). This is a dangerous situation: inflation can become
self-fulfilling. In words of Robert Solow, a Nobel
prize winner: “Why is our money ever less valuable? Perhaps it is
simply that we have inflation because we expect inflation, and we expect
inflation because we’ve had it.” Once economy happens to be in
such high inflation equilibrium, it is hard to get out from it. Given that
Ukraine has had high and volatile inflation since its independence, it may seem
that the situation is hopeless and forecasting inflation at long horizons is
futile. Yet, this is a wrong view.
Figure 1. Inflation rate in Ukraine
The National
Bank of Ukraine (NBU) declared a
new monetary regime: inflation targeting. The NBU announced a
path for the future rate of inflation gradually decreasing from current heights
to approximately 12% in 2016, 8% in 2017, 6% in 2018, and 5% afterwards. As
a part of this new regime, the NBU promised to let the hryvnia float. This is a
bold step given that many Ukrainians use the exchange rate to measure the
purchasing power of the hryvnia, a common misconception and mistake. If one
believes this regime change, then the forecast for inflation in 10 years from
now should be 5%.
There are two
related questions. First, how can one make this regime work in
practice? Second, is it going to work in Ukraine?
To answer the
first question, consider the standard expectations-augmented Phillips curve, which
links nominal variables (inflation) to real variables (output, unemployment):
πt inflation = Etπt+1 inflation
expectations – γ*(Ut–U) unemployment gap
This
relationship suggests that inflation today depends on expected inflation (the
first term on the right-hand side of the equation) and on how much slack one
has in the economy (the second term). High inflation expectations translated
one-for-one into current inflation and, in this sense, controlling inflation
expectations is absolutely crucial. One can also reduce inflation by
generating slack, that is, increase unemployment Ut above some equilibrium
level U.
Controlling
expectations is a challenging task. The NBU has to prove its credibility as an
institution averse to inflation. How can this be done? A classic example is the
Volcker disinflation in the U.S. in the early 1980s. At that time, the U.S.
economy had double-digit inflation. Paul Volcker was
appointed to combat inflation. Few people believed that this was a serious
attempt and thus the mere fact that Volcker was a new chair of the Federal
Reserve System (the Fed) meant little for inflation dynamics. To establish
credibility, Volcker had to raise interest rates to unprecedented levels. This
policy resulted in the second-largest U.S. recession in the post-World War II
era. Unemployment skyrocketed to 10 percent. But it sent a signal that the Fed
was serious about inflation. Inflation was crushed: within a few years, Volcker
brought inflation and inflation expectations down to 3 percent. In short,
Volcker had to use both channels (change people’s expectations and generate
unemployment) to disinflate.
Figure 2.
Inflation dynamics during the Volcker disinflation in the U.S.
Notes: the
vertical axis measures the deviation of inflation from expected inflation
(one-year ahead inflation, Michigan Survey of Consumers). The horizontal axis
shows the deviation of unemployment from equilibrium level (approximately 6
percent). The red line shows the slope of the fitted linear regression
(parameter γ in the Phillips curve).
Since Volcker
achieved disinflation, inflation and inflation expectations have been in check
(see Figure 3). The Fed has established its credibility and now even relatively
minor moments in the interest rates controlled by the Fed send a powerful
stabilization signal. The amount of credibility is striking: after Fed did
massive injections of liquidity into the ailing economy during the Great
Recession, there was no great inflation fear.
Figure 3.
Inflation and inflation expectations in the U.S.
Now we know the
answer to the first question: it can be done, but it involves temporarily lower
growth or even a recession.To answer the second question, we can examine
experience of other countries that used inflation targeting to dis-inflate and
to control inflation afterwards. Figure 4 shows the dynamics of inflation for
New Zealand (the pioneer of inflation targeting) and Poland (Ukraine’s neighbor
and “role model”). In both cases, inflation was reduced within a few years and
remained stable for many years. Even during the recent global finance crisis,
inflation was remarkably stable. During the disinflation process, there was no
major recession. Is this a general pattern?
Figure 4. Inflation dynamics in Poland and New
Zealand
The answer is
“yes”. I take all countries that formally adopted inflation
targeting and examine how inflation was reduced. Figure 5 presents
average dynamics of inflation (left panel) and unemployment (right panel) since
the start of inflation targeting. Within a few years, inflation on average is
reduced by 4 percent. In the top quarter of cases (countries more successful in
reducing inflation), inflation fell by 8 percent. This is not costless. Similar
to the Volcker disinflation, the transitional period is associated with
unemployment being increased by two percentage points. This is a considerable
cost but it is much “cheaper” than the cost during the Volcker disinflation.
Figure 5.
Average dynamics of inflation and unemployment since the start of inflation
targeting
If inflation
targeting works for other countries, is it going to work in Ukraine? The answer
depends on the commitment of the NBU to fight inflation. So far,
the central bank keeps nominal interest rates well above expected inflation.
This is a sign of tight monetary policy aimed at disinflation. So in the short
run, the commitment seems to be there. For the longer run, one may note that
recent changes in legislation gave more independence and powers to the NBU to
ensure it focuses on fighting inflation and is insulated from political
pressures. Thus, there is some assurance that the new regime is here to stay.
If so, inflation will be about 5% in ten years from now.
How can the NBU
make the transition easier? First, communication plays a central
role in inflation targeting because it gives the central bank a direct tool to
influence and control inflation expectations. The NBU should make every effort
to reach out and convince people that the new regime will bring inflation down. Second,
given the sensitivity of
inflation expectations to the UAH/USD exchange rate, minimizing swings in the
exchange rate can help stabilize inflation expectations of households and
firms. However, this policy can be used only to the extent it does not
contradict the main objective of the central bank: fighting inflation. Third,
the central bank and, more importantly, the public should guard the
independence of the NBU.
This article was originally published at VoxUrkaine. All Rights Reserved by the
Original Publisher.
