Managing costs of economic scarring

Monetary policy decisions can be tough pills to swallow. Kevin Warsh, in his press statement as the new Federal Reserve chairperson, reiterated a central bank’s main objective — price stability.

In other words, bring inflation down and keep the exchange rate stable. The other objective — sustainable growth — often comes second, which is reasonable because excessive growth can spur higher inflation.

I would argue, however, that growth is sometimes necessary to keep inflation stable over the long term. Such times arise when economies experience massive supply shocks, especially when they occur in succession, such as the Covid-19 pandemic, the Russia-Ukraine war, and now the Iran-US/Israel conflict.     

The whipsaw effects on demand, supply, inflation, and interest rates during and after each shock can leave persistent, if not permanent, economic scars that affect both medium- and long-term productive capacity.

When the Philippine Statistics Authority reported May inflation earlier this year, investors cheered. The deceleration to 6.8 percent in May from a surprise spike of 7.3 percent in April was a positive development. It opened the possibility that the Bangko Sentral ng Pilipinas (BSP) would consider pausing its monetary tightening policy.

Stock markets can be negatively affected by rising interest rates because they increase the cost of doing business. However, central banks such as the BSP use interest rates to manage inflation and the exchange rate in order to prevent the economy from overheating.

This occurs when too many pesos are chasing too few goods. With inflation slowing, there appeared to be a chance that the worst was over, especially since oil prices remained subdued and had room to improve following the peace agreement between the United States and Iran, which would allow the reopening of the Strait of Hormuz.

Unfortunately for the stock market, the BSP announced another 25-basis-point increase in its policy rate to 4.75 percent.

Moreover, the central bank signaled that it is not yet done, as it released inflation forecasts for 2026 to 2028. Their models suggest that average inflation will continue to be above target in 2026 and 2027 and that it will only normalize in 2028.

The BSP’s concern over inflation could be a symptom of economic scarring. One example is the prolonged lack of appetite for investment spending.

It has been argued that the oil shock and high inflation of the early 1970s depressed investment and innovation in the United States, resulting in a loss of productivity in the late 1970s and early 1980s.

This productivity loss contributed to persistently high inflation during that period.

The economic scars of the Philippines in the 1980s continue to be felt today, as evidenced by high electricity costs driven by insufficient investment in power generation and transmission capacity. If you are complaining about your electricity bill, part of the reason can be traced to that period of scarring.

The 2023 study by Luca Fornaro and Martin Wolf on the monetary policy implications of supply-shock scars provides a theoretical basis for this argument.

They argue that economic scars may reinforce the inflationary effects of supply shocks and that contractionary monetary policy may deepen those scars and prolong inflation.

While this makes me wary of the broader macroeconomic effects of current policy-rate directions, I believe they remain necessary.

Core inflation is rising and has maintained its momentum. The BSP is trying to anchor inflation expectations, and that is critical for macroeconomic stability.

Although industries may become more cautious after being hit by economic shocks, the counterintuitive recommendation is to continue pursuing growth through investment, expansion, and reinvestment in existing assets.

Government can help by providing incentives or subsidies to support sustained growth, even as the central bank does its best to preserve macroeconomic stability through a measure of tough love.

(Jose Mari Lacson is the director and head of macroeconomics and impact investing at ATR Asset Management. He holds a PhD in economics from De La Salle University.)