Inflation expectations

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Monetary policy requires managing expectations of future inflation and interest rates. The importance of keeping inflation expectations low cannot be overemphasised. Once firms expect higher inflation, they will anticipate it by trying to pass on cost increases to consumers. True, in the current Covid context, employees are not in a position to bargain for better wages, but to the extent that they base their expectations on the recent past, this can lead to a persistent rise in inflation. Monetary policymakers, though, should not adopt a backward-looking approach.

Inflation is coming back with a vengeance. The annual average inflation in Mauritius has been going up steadily, from 0.5% in November 2019 to 2.5% in December 2020. It reflects the official consumer price index, but the real inflation suffered by poor consumers can be stronger. For instance, between September and October 2020, the change in CPI for food and non-alcoholic beverages was -0.5 point (deflation), but within this division it was +0.1 point for vegetables, which are mostly consumed by the low-income earners. In the same vein, the change in index point for education was +3.2 (high inflation), but only +0.1 for university fees in private institutions, which are attended by people of means.

For the year 2021, the Bank of Mauritius is forecasting an inflation of 3.0%, a rate which is alarming enough to trigger an interest rate tightening. Yet, the problem for central banks is not an increase in headline inflation, but higher inflation expectations. That is why policymakers must be able to communicate effectively. Alas, few can understand the views of our Monetary Policy Committee.

In the face of an ultra-expansive monetary policy, markets are expecting a strong signal that rate cuts are done. Instead, the minutes of the last MPC meeting contain dovish statements, notably that “underlying inflationary pressures were expected to remain subdued”, that “demand-side pressures are projected to be minimal”, and that “global oil prices are foreseen to stabilise at current levels.”

While our MPC members are not worried about inflation, worldwide inflation fears are running rampant, commodity prices are surging, bond yields are climbing, and the 5-year forward inflation rates in the United States and in Europe are ticking up. Brent crude has more than doubled and trades 70 dollars a barrel: a hike in the local petrol prices at the pump is inevitable, the more so as the rupee has depreciated against the greenback.

The MPC further stated that “inflation expectations remained adequately anchored.” Such a subjective opinion does not hold water. The results of the last three auctions of 15-year inflation-indexed Government of Mauritius bonds give an indication of long-term inflation expectations. Despite annual average inflation rates trending downwards (5.0% in March 2018, 1.4% in March 2019 and 0.8% in February 2020), the highest bid margin received kept on widening (400 basis points in April 2018, 500 points in April 2019 and 525 points in March 2020). So inflation expectations were not stable on the way down – when inflation was receding – and they will neither be stable on the way up.

For now, people are not spending, hence a lot of pent-up demand, but there is massive monetary pumping by the Bank of Mauritius whose balance sheet has swelled by 50% over the past 12 months. As broad money liabilities expanded by 17.2% year-on-year in January 2021, Moody’s sees “a risk that the large expansion of the monetary base increases inflationary pressures that prove hard to contain.” At the same time, real budget deficit and gross public debt as a share of GDP are worsening. More stimulus will only fuel the fire of inflation.

With its reputation tarnished by reckless monetary and fiscal policies, the dovish Bank of Mauritius cannot ignore the perils of high inflation, as befits a forwardlooking central bank. In view of the buoyant consumer inflation numbers, it is seen as being behind the curve. By letting the inflation genie out of the bottle, it could take many years to put it back in. With rapid economic normalisation, a spike in inflation could force the MPC to jack up the Key Repo Rate more steeply than expected in order to keep a lid on inflation.

The MPC said “they deliberated on the importance of core inflation measures and on the merit for targeting core inflation.” The core rate, which strips out prices of commodities that are deemed too volatile, namely food and energy, are useful only as a predictor of future headline inflation. A central bank should target overall inflation rather because it has broad effects on the economy.

Owing to a stubbornly high year-on-year Core2 inflation of 4.5% in February 2021, the Bank of Mauritius must show real concerns about runaway prices. Even if this raises borrowing costs, a hike of 50 basis points in the policy rate, sooner rather than later, would at least hold down inflation expectations.

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