Currency basket could control inflation

 

The UAE economy has been one of the fastest-growing in the world, with an average real growth rate of 9.7 per cent from 2003 to 2007, and forecast to grow at similar, though moderately lower, rates in 2008 and the medium term.

We have two drivers of inflation. Strong growth of aggregate demand compared to supply has raised the prices of non-traded goods and services. In particular, the demand for housing and office space has been coupled with infrastructural bottlenecks and a time lag for housing and office supply to hit the market.

The result has been soaring rentals that accounted for about 36 per cent of the increase in the Consumer Price Index in 2006. However, this is a temporary phenomenon, which will subside as equilibrium returns to the real estate market. High rentals and returns to real estate investment are leading to increased supply of housing and office space, which will lead to a new equilibrium in the market.

The other driver is imported inflation due to the dollar peg. The depreciation of the greenback has resulted in higher prices of imported goods from Europe and Asia and Japan, which are the UAE’s main trade partners. However, unless the dollar continues to depreciate, we should not expect imported inflation to persist.

As a corollary of the peg to the dollar, the UAE cannot follow a monetary policy independent of that of the US Federal Reserve.

Since 2006, US monetary policy has been geared at ensuring a soft landing for the American economy and, more recently, mitigating the risk of a major financial crisis resulting from the sub-prime mortgage market and credit market crunch. This has led the Fed to lower interest rates. The UAE and GCC countries have been forced to maintain a similar interest rate policy stance, unable to use interest rates to rein in aggregate demand growth.

 

Relatively low nominal interest rates accompanied by higher inflation results in lower real interest rates (nominal interest rates corrected for inflation), implying a disincentive to save. As a result, the UAE has experienced higher consumption and investment rates, which fuel aggregate demand, a credit boom and a flight towards real assets as a hedge against inflation. A degree of freedom for monetary policy could be obtained if the authorities generate greater exchange rate flexibility by pegging to a basket of currencies (including the dollar, euro and yen).

 

Over the medium term, however, it may be advisable to implement an inflation-targeting policy.

 

The writer is the Chief Economist at the Dubai International Financial Centre.