In a bid to combat inflation, central banks must evaluate the advantages against the possible adverse effects on their transparency and credibility, particularly in situations where monetary and fiscal policy frameworks are not firmly established.
- Monetary and fiscal policy are two powerful tools that governments use to steer economies.
- Public debt ratios have peaked at their highest levels in more than two decades, and several low-income African nations are in or near economic shutdown.
- Experts have projected that total inflation in sub-Saharan Africa will reach 12.2 per cent in 2022.
Understanding monetary and fiscal policy
Monetary and fiscal policy are two powerful tools that governments use to steer economies. When applied correctly, these tools can similarly stimulate an economy and slow it down when it heats up.
Fiscal policy is when a government uses its spending and taxing powers to impact the economy. Monetary policy relates to the techniques a country’s central bank uses to check the amount of money in circulation and its value to the economy.
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The combination and interaction of government expenditures and revenue collection is a delicate balance that requires proper timing and a little luck to get it right.
Fiscal policy’s direct and indirect effects can influence personal spending, capital expenditure, exchange rates, deficit levels, and even interest rates, usually associated with monetary policy.
African nations currently confront significant monetary and fiscal policy issues. The pandemic slowed economic growth, and the recovery will probably leave production below the pre-crisis level. Several African countries have seen inflation rise in recent months. The rising inflation has posed a problem exacerbated in certain instances by fiscal dominance from high levels of public debt.
Many of these economies may experience capital outflows as well. In the coming months, major central banks in advanced countries will reduce policy stimulus and hike interest rates. The economic effect of the Ukrainian war, notably the consequent rapid surge in oil and food prices, is expected to exacerbate the issues. The biggest question is how African nations will react to and deal with this highly volatile situation.
Shielding against vulnerabilities with debt sustainability considerations
Public debt ratios have peaked at their highest levels in more than two decades, and several low-income African nations are in or near economic shutdown. As a result, protecting the most vulnerable families without jeopardizing debt sustainability must remain a priority.
Fiscal policy must support disadvantaged families from rising food and energy costs while not increasing debt vulnerability. The first-best approach is targeted cash transfer programmes to needy families. However, targeted tax cuts or price subsidies may be a better second-best option, particularly in nations with low social safety nets.
Finding the resources to safeguard the disadvantaged may need a reprioritization of expenditure in nations with tighter economic restrictions. Higher commodity prices, on the other hand, may produce a fiscal windfall in commodity-exporting countries. However, given the uncertain forecast and often unstable budgetary conditions, most of these advantages should help to strengthen policy buffers.
It will be tough to navigate this complicated policy route, and many nations will need international assistance. While international bodies such as the IMF have been a steady source of help, the international community could go farther, for example, by eliminating barriers to allow for rapid and efficient debt restructurings where necessary.
Addressing inflation amidst tight monetary and fiscal spaces
Consumer price increases have significantly varied throughout African nations. On the other hand, rising inflation is a common tendency throughout the continent. Experts have projected that total inflation in sub-Saharan Africa will reach 12.2 per cent in 2022. The rise is part of a global trend in which consumer prices are rising all around the globe, affecting both advanced and developing economies.
Although inflationary pressures do not have uniform causes, a few similar forces have driven up prices in several nations. Supply disruptions induced by the coronavirus (COVID-19) epidemic continue to plague economies globally. Furthermore, the Russian invasion of Ukraine has caused energy and food costs to skyrocket.
African nations must prioritize controlling inflation without compromising the recovery process. With growing inflationary pressures and production levels below pre-pandemic levels in most economies, central banks must strike a tough balance between containing inflation and promoting growth. Authorities should keep a close eye on inflation and be ready to raise interest rates if required while sustaining credible and well-communicated policy frameworks.
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Currency exchange rate considerations
Currency depreciation may be a beneficial shock absorber for nations with more flexible arrangements. Still, it can complicate the prospects for those with foreign-currency debt or when depreciation rapidly flows through to domestic inflation. Contrasting monetary and fiscal policy on domestic goals allows currencies to adapt. The adaptation benefits countries with managed or free-floating exchange rate regimes.
Foreign exchange intervention may assist counter excessive exchange rate fluctuations in this respect. However, low international reserves frequently limit the scope for intervention. In certain instances, monetary tightening may be required to sustain the currency, even if economic activity is sluggish.
However, the peculiarities and vulnerabilities of African nations with floating exchange rate regimes might restrict the advantages of entirely flexible rates. For example, dominant currency pricing (i.e., fixed export prices in US dollar terms) might undermine the advantageous trade adjustments associated with flexible rates.
Furthermore, shallow markets (those with insufficient liquidity) may accentuate exchange rate swings and produce excessive volatility. Many nations in Africa have shallow foreign exchange markets, as shown by significant gaps between ask and bid prices.
Foreign-currency obligations
High foreign-currency obligations are also a significant risk in several countries. Exchange rate depreciation may jeopardize company and individual financial health when there are substantial currency mismatches on balance sheets. Furthermore, insufficient central bank confidence might cause exchange rate movements to have a greater impact on inflation.
Currency mismatches and significant passthrough may lead production and inflation to shift in opposing directions aftershocks, exacerbating policymakers’ decisions.
There is also evidence that the exchange rate passthrough is much greater in low-income nations than in more sophisticated ones. This is especially problematic considering the country’s frequent reliance on food and energy imports. In terms of economic policy, governments confront immediate concerns in the near run, given recent food and energy price patterns.
Bottom-line
Countries must continue to work to mitigate their vulnerabilities over time. This involves minimizing balance-sheet misalignments, establishing money and foreign exchange markets, and lowering exchange rate passthrough by increasing monetary policy credibility.
However, in the short term—while vulnerabilities remain high—the use of extra instruments may assist relieve short-term policy trade-offs when certain shocks occur. In particular, foreign exchange intervention, macroprudential policy measures, and capital flow controls may help increase monetary and fiscal policy autonomy, promote financial and price stability, and minimize output volatility if reserves are enough and these instruments are available.
A few crucial qualifications are for central banks contemplating such programs. Importantly, the instruments should not go towards the maintenance of an overvalued or undervalued currency. Furthermore, although new tools might assist mitigate short-term trade-offs, this advantage must be carefully balanced against possible long-term costs. Reduced incentives for market growth and effective risk management in the private sector are examples of such costs.
Communicating about the collaborative use of various instruments in a more complicated framework may also be difficult. Furthermore, broadening the variety of policy alternatives may expose central banks to political pressures. As a result, central banks must evaluate the advantages against the possible adverse effects on their transparency and credibility, particularly in situations where monetary and fiscal policy frameworks are not firmly established.
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