The Phillips Curve and Imported Inflation
The index increased after the public heard that US inflation had skyrocketed above its long-term average (around 2 percent) since April 2021.
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The atmosphere of loading and unloading of export-import containers at Tanjung Priok Port, Jakarta, Friday (1/9/2021).
The plan of the United States’ central bank, the Federal Reserve (the Fed), to reduce the pace of its net asset purchases has become an interesting topic of discussion because of its great impact on the global market.
Investors in the financial market seem to have factored the Fed’s plan into their business calculations. A potential reversal of capital flows to the US as a safe haven can be seen from the surge in the US Dollar Index (USDX), which indicates the strength of the currency.
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The USDX has been increasing since June 2021, when the index was still in the 90s. The sharp increase in the index began November, and by the end of 2021, the index reached 95.7.
The index increased after the public heard that US inflation had skyrocketed above its long-term average (around 2 percent) since April 2021. The question is why the Fed maintained a dovish tone on inflation until November that year. The answer can be seen in the Phillips curve, which illustrates an economic pattern.
Phillips curve
Before the pandemic, there was widespread discussion among economists about a flat Phillips curve (Kuttner and Robinson, 2010). The Phillips curve represents the inverse relationship between inflation and growth, or between inflation and unemployment: the higher the growth, the higher the inflation; alternatively, the lower the unemployment, the higher the inflation.
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Subsequent developments show that the relationship between inflation and growth has been weakening with the fall in US annual inflation. This has led to a belief that the Phillips curve has disappeared or has become flatter. This means that the relationship between the output gap and inflation is getting weaker.
This is the result of the Fed policy that has succeeded in stabilizing inflation expectations by targeting inflation credibility. The Fed is mandated to impose monetary policies to maintain household welfare by minimizing fluctuations (standard deviations) between the output gap and inflation.
With the Phillips curve flattening, the Fed's task looks easy at first glance, merely to guide inflation expectations. It looks like the US economy has become immune to shocks, even though it is also important to consider the scale of the shocks. Another factor is the change in the structure of global production, which can quickly close deviations in normal output by the more efficient global supply chains (Goodhart and Pradhan, 2019).
With many countries imposing mobility restrictions to mitigate the impacts of the pandemic, the efficiency of global supply chains has fallen to near zero.
The inflation in 2021 amid the ongoing pandemic caused structural shocks so great that the inflation-growth relationship returned to pre-2000 levels. With many countries imposing mobility restrictions to mitigate the impacts of the pandemic, the efficiency of global supply chains has fallen to near zero.
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At the same time, the US government implemented a policy to pay stimulus checks to eligible households. Meanwhile, the Fed also purchased financial assets to support liquidity. In this regard, the demand side is like a car with an engine equipped with a turbocharger.
On the other hand, the production (supply) side was unable to respond quickly as a result of a lack of manpower, rising energy prices and logistical disruptions at ports and in trucking. This combination caused a sharp increase in the inflation rate. The US consumer price index (CPI) rose to 6.8 percent in November 2021, the highest since 1982.
Inflationary pressures caused the Phillips curve, which was previously said to have disappeared, to rise again, and the Fed became more aggressive (hawkish) on inflation.
The Fed immediately indicated a policy change (pivot) towards tapering. A US survey conducted by the CNBC for respondents that included leading economists and reputable portfolio fund managers projected that by March 2022, the Fed would stop buying financial assets. The tapering program started in December 2021 with a purchase reduction of $30 billion per month. The Fed also signaled that there would be three rate hikes in 2022, to be followed by three more in 2023.
The message from the tapering policy is that Indonesia must be aware of lines of transmission to the domestic economy through inflation from global supply chains and the surge in the exchange rate surge. Annual inflation in November was 1.75 percent, the highest in 2021.
The question is whether the upward inflation trend indicates an increase in demand, which has been severely affected by mobility restrictions, or if this is due more to the rigidity of the supply side, both domestic and international, originating from raw materials and semi-finished goods imported for domestic production.
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Viewed from expenditure groups, inflation has occurred on the production side. The food and beverage and tobacco sectors were the biggest contributors to November inflation. This group indicates price inelasticity of demand. The inflation was due to imported goods, exchange rates, and seasonal factors such as rain and flooding.
What should be noted is the impact of fragmentation in the global supply chain, as shown by the increase in the price of cooking oil in the food category as a result of the increase in global palm oil prices. The price increase was caused by an increase in demand and the chain effect of the world energy crisis.
The rupiah exchange rate will affect inflation through imported goods, including finished goods, raw materials and capital goods. The rupiah rate declined to Rp 14,400 per US dollar in October and November 2021, indicating that the impacts of the change in the Fed policy towards tapering and the increase in the USDX should be anticipated.
The balance of trade recorded a surplus for the 19th straight month to exceed net capital outflows.
According to Bank Indonesia, 2021 saw a net outflow of Rp 80.92 trillion from the government securities (SBN) market and a net inflow of Rp 38.09 trillion to the stock market. The balance of trade recorded a surplus for the 19th straight month to exceed net capital outflows. This also contributed to the strengthening of rupiah exchange rate at the end of 2021 to Rp 14,250 per US dollar.
Looking ahead, the amount of the trade surplus will determine the amount of imported inflation, especially with the expected increase in imports as a result of improving economic activities. In addition, as regards managing the flow of investment portfolios, the Fed's benchmark interest rate needs to be monitored in order to maintain interest rate parity.
ARI KUNCORO, Rector of the University of Indonesia
(The article was translated by Hendarsyah Tarmizi).
