The new norm of tepid growth and inflation

Inflation is here to stay, as economic restructuring bites

By Aaron Low, The Straits Times, 23 Oct 2012

AFTER consecutive months of seeing inflation ease off, one would have thought that the battle against inflation was starting to turn the tide, and that the focus can turn towards addressing growth.

Not so. Earlier this month, the central bank sent out a stark reminder that inflation was still a primary threat, even though growth is clearly grinding to a halt.

Exchange rate unchanged

THE Monetary Authority of Singapore (MAS) kept its exchange rate policy unchanged - its way of saying inflation worries still outweighed growth concerns - defying market expectations of a policy easing.

The MAS uses the exchange rate policy to balance between growth and inflation.

Too high an exchange rate and Singapore's competitiveness could be affected but too low an exchange rate and Singapore could be hit by high prices of imported goods.

The move was both startling and worrying at the same time.

Before the policy statement, most economists were convinced that the MAS would relax the Sing dollar's appreciation stance. After all, inflation had fallen to 4 per cent in July and then again to 3.9 per cent in August.

At the same time, there were worrying signs that growth was on the slide down. Exports fell by double digits in August, while forward indicators for the manufacturing sector had been pointing south for several months.

The expectation was thus that the central bank would shift its policy to address growth rather than inflation.

The downbeat data was confirmed when the Trade and Industry Ministry said the Singapore economy contracted 1.5 per cent in the third quarter, compared with the three months before.

Instead, the MAS introduced two new pieces of information to the inflation and growth debate, which now changes the picture significantly.

Slow growth, strong jobs

ONE is that while growth has slowed, it's not gone so bad that it deserves immediate attention.

One of MAS' key assumptions about slow growth is that the recent stimulus by the US Federal Reserve and the European Central Bank will likely avert a deep global recession.

This should mean Singapore is still on track to achieve a growth rate that is within the official forecast of 1.5 per cent and 2.5 per cent for this year.

But more importantly, even as growth slows, the labour market, which looks increasingly important in influencing policymakers here, remains strong.

As RBS economist Enrico Tanuwidjaja noted, Singapore seems to be more tolerant of low growth rates if the job market stays firm. History shows that it has.

The unemployment rate stood at 2 per cent in June, one of the lowest in the world. MAS believes that the economy will see full employment next year as well.

The second element, which is also related to the job market, is that the sources of inflation are rapidly changing.

MAS said inflation next year could still hover at the 3.5 per cent to 4.5 per cent range, still significantly higher than the 30-year historic rate of 2.2 per cent.

While car prices and housing costs are likely to contribute to the bulk of inflation, it is the tight labour market that MAS is casting nervous glances at. It flagged that higher consumer prices could result from rising wages in a tight labour market, as firms pass on wage costs to their customers.

In fact, MAS, known for carefully selecting its words, emphasised that there is a tight labour market not once but three times in its statement.

As Barclays Capital economist Leong Wai Ho noted: "It appears that structural constraints in factor markets (curbs on foreign- worker inflows, peak in indigenous labour force) could be greater than we expected."

The Government has deliberately embarked on reducing reliance on foreign workers, in order to raise productivity and wages of Singaporeans.

Most economists agree this is a big part of the reason for the tight labour market.

The new normal?

THEREIN lies the dilemma for MAS.

Much of today's and tomorrow's inflation can be attributed to the Government's own policies, such as the low numbers of COEs and a tight foreign worker policy.

The most obvious solution is for the Government to relax the foreign worker policy. But that would be politically unpalatable, given the great unhappiness Singaporeans have against over-crowding as well as the Government's overriding objective to reduce reliance on foreign workers.

In fact, Deputy Prime Minister and Finance Minister Tharman Shanmugaratnam has consistently maintained that there will be no U-turn on this particular policy.

Monetary policy, in this case, plays only a limited role in directly affecting inflation. It can compensate for domestic inflation by reducing imported inflation further - but since imported inflation is already muted, this would be at best an indirect solution.

Another way it can lower inflation is through dampening economic activity, so that the economy does not overheat.

DBS economist Irvin Seah thinks that MAS is sacrificing growth to combat inflation.

"What's worrying is that Singapore is fast losing its competitiveness in the export sector, with costs rising rapidly. A stronger Sing dollar hardly helps," he said.

But it would be illogical for MAS to want to send the economy into recession.

No. What has changed is the parameters of the growth and inflation debate.

One, the current global economic malaise is likely to stay for years, if not more. What we are seeing now - slow grinding growth and tepid pace of expansion - are likely to be regular features of the global economy in the near future.

So while Singapore is unused to seeing growth rates of 1 per cent to 3 per cent, it will likely experience much more of the same in the near future.

This is the new norm of growth and policymakers are clearly adjusting to this new level.

The second change is that higher inflation is here to stay. Increasingly, at least while the deliberate restructuring of the economy takes place, policymakers seem to have a higher tolerance for this elevated level of inflation.

What is probably more important for MAS right now is to anchor inflation expectations.

When people see inflation numbers being reported in the newspaper, they make decisions about what to spend, how much to save and whether they should be getting a pay rise.

If they expect that inflation should keep rising at a rapid pace, they may decide to spend more now, save less for the future and demand higher wages to keep up with the cost of living.

That in turn pushes inflation even higher, and this, if left unchecked, could spiral into runaway inflation.

CIMB economist Song Seng Wun believes that the recent monetary policy statement is meant more as a signal than to be used as a direct tool. "They are telling bosses and people, hey we are concerned about inflation and you should be too. In so doing they hope to anchor inflation expectations," he said.

Indeed, it was instructive that MAS itself said in its statement that its policy stance "is assessed to be appropriate in containing inflationary pressures and keeping the economy on a path of restructuring towards sustainable growth" (emphasis added).

In layman terms, what this all means is that people should be prepared for higher inflation for the next few years as the economy restructures. There will be pain as prices rise to reflect higher wages of people in the services industry and other sectors where companies are unable to find foreign workers to fill positions.

Productivity might help offset some of the higher costs but gains will be uneven and not all companies in all sectors can raise productivity as much as wages. Some will be passed on to customers.

This is not a bad thing if the goal is to raise the wages of the lower-paid Singaporeans working in these sectors.

There are trade-offs in any policy and maybe, in this case, higher inflation is the necessary evil that we have to contend with to have a more equitable society.