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Monetary Policy, De-leveraging and Deflation in the UAE

Published on: June 2009​
Genre: Economics/Finance​ Category: Op eds​
The biggest proportion of the consumer price index, or CPI, for the UAE is housing. The fall in the real-estate market has caused inflation to fall.

This may seem like good news for consumers but the profit squeeze resulting from slower price increases or an outright deflationary episode may eventually translate into lower money wages and increase the rate of unemployment. Consumers’ perceived gains from an eventual deflation may be just another case of “money illusion”: If money wages fall by the same proportion as prices, purchasing power is unlikely to change much.

We know that the high inflation rates and inflation volatility experienced in the UAE in the past few years have been a consequence of high levels of economic growth and high oil prices. They have also negatively impacted growth both in the UAE and the GCC since its creation in the early 1980s.

This of course reflects in part the costs of the fixed exchange rate regime that Gulf States have adopted in the past few decades; clearly a second-best policy given institutional challenges that are present in the Gulf. What are the real risks associated with a prolonged deflationary episode in the UAE?

Before we answer this question, let’s see what constitutes the main problem posed by a so-called “deflationary trap”: a well-functioning economy has a rate of output growth that corresponds to some stable rate of inflation.

This is why many big economies like the UK, the US and the Eurozone have a (more or less explicitly-defined) policy of using monetary policy to target a rate of inflation. The inflation targeted is typically small but positive: somewhere around 3-5 per cent. Under these conditions, output grows from one year to the next and inflation remains in check: if it is too high, the nominal interest rate can be increased to slow down the economy, and so on.

This monetary policy tool however may not be of much use to stabilise the economy in a deflationary episode: since the lowest nominal interest rate that can be set is zero, the corresponding real interest rate (nominal rate minus inflation) would be positive! This would discourage investment and employment and would reinforce the deflation. These episodes happen and can be prolonged: a prominent example of this is the economic slump that Japan experienced beginning in the late 1980s.

The UAE central bank of course cannot target a rate of inflation. This is because the monetary policy tool in this country is used to target an exchange rate. Consequently the very notion of a deflationary trap has to be seen within the context of particular features of the UAE economy.

First, the de-leveraging in the real estate and stock market is happening en masse: as a result, individual attempts to pay down one’s debt are being hampered by others’ attempts to do exactly the same thing. The resulting negative wealth effect is causing a fall in demand. Second, in a fixed exchange rate regime this fall in demand causes a lower demand for the domestic currency. Since the central bank has to maintain the fixed exchange rate regime, it has to reduce supply of the domestic currency. This exacerbates the slow-down in demand and will result in a sharper fall in output growth in the UAE. Third, the deflationary episode will eventually be driven by below-potential output, and not by the de-leveraging.

Below-potential output drives down wages and prices and causes the real exchange rate to become more competitive. This in turn translates into an increase in exports and a corresponding increase in output. This process continues until output stabilises at a level at which inflation is (relatively) stable.

Deflation for an open economy with a fixed exchange rate has therefore two effects on output growth: in the short-term, the negative effect on investment as real interest rates rise causes output to fall (this is exacerbated by the current monetary regime) but in the longer-term, this same deflation (caused this time by labour-market dynamics) will cause output to recover.

So, should we be worried about deflation? Authorities in the UAE and elsewhere have done a good job in mitigating the consequences of the financial crisis; in addition, the current fall in the US dollar will drive up inflation in the UAE because of the currency peg and the recovering oil prices will further mitigate deflationary risks by pumping fresh money into the economy. There are also signs that this recovery has boosted prices in the local stock market. The question then is how to avoid another episode of de-leveraging that got us into this mess in the first place.

Tarek Coury is an assistant professor at the Dubai School of Government.

This article was originally printed in The Khaleej Times. It can be accessed here.

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