The risks that U.S. inflation brings to the rest of the world

Editor's note: C. Saratchand, a special commentator on current affairs for CGTN, is a professor at the Department of Economics, Satyawati College at the University of Delhi in India. The article reflects the author's opinions and not necessarily the views of CGTN.

The International Monetary Fund has cautioned the United States that its substantial fiscal deficits have fuelled inflation and present "significant risks" for the worldwide economy.

The virtual doubling of the fiscal deficit of the U.S. government (as a fraction of GDP) in the past two years has not only increased output but also the rate of inflation in the country. The rise in output has increased employment and the wage bill, but a substantial section of U.S. workers are finding it difficult to meet basic needs such as housing, food and transportation. In other words, the rise in inflation has partly negated the stimulating effect of the fiscal expansion.

But why has inflation increased sharply in spite of wages not rising to a similar extent? First, the ever-expanding scope of U.S. import tariffs on Chinese commodities has increased U.S. prices since there exists no large scale alternative supplier for such commodities. These import tariffs have also resulted in Chinese commodities being imported into the U.S. after last-mile processing at alternative locations. This too has increased these import prices ironically due to policy driven spatial dispersal of global production networks.

Second, the fiscal expansion in the U.S. has resulted in capacity constraints being on the verge of being breached for at least some commodities. To the extent that these are primary commodities, speculation has caused prices to rise. These prices were already tending to rise due to the vain efforts led by the U.S. government to impose unilateral sanctions on the Russian Federation. These unilateral sanctions have instead resulted in German de-industrialization and therefore broader European economic atrophy. For manufactured commodities and services, higher domestic capacity utilization has resulted in U.S. firms, protected by import tariffs, hiking profit margins.

The U.S. Federal Reserve has kept the policy interest rate high to try and prevent inflation from accelerating. Additionally, a higher policy rate of interest may amount to a counter move by the U.S. to try and delay moves towards de-dollarization. However, the heightened level of the policy rate of interest in the U.S. is unlikely by itself to rein in inflation in the U.S., since the causes of this inflation are, as argued previously, partly due to import tariffs and partly on account of higher profit margins.

Extremely high rates of interest will rein in inflation, but it will also cause output and employment to fall precipitously, which would not be politically circumspect, especially in an election year in the U.S.  

Meanwhile, the heightened level of the policy rate of interest in the U.S. is having deleterious impacts on many developing countries. First, this will compel central banks in developing countries to increase their own policy interest rates to try and defend their exchange rates.

If they are successful in this endeavor, then their high policy interest rates will cause a domestic economic contraction or slowdown, since credit financed expenditures will face attenuation, along with a rise in domestic debt default. But if the central banks of these developing countries are unsuccessful, there will be destabilizing capital outflows, which may become self-referential and thus lead to a currency crisis followed by inflation.

Output contraction or slowdown is also likely to happen in these circumstances in many such developing countries for the following reasons. To begin with, the demand from these developing countries for imported intermediate commodities, such as oil, is inelastic with respect to exchange-rate-depreciation-induced price increases.

Further, exports of such countries (usually producing primary commodities and manufactured commodities that are at the lower reaches of the technological ladder) are unlikely to rise significantly when there is an exchange rate depreciation, given that governments of developed countries are increasing trade protection. Thus the currency crisis-driven exchange rate depreciation will lead to output contraction through the channel of foreign trade in these developing countries.

Second, to the extent that interest rates at which developing countries borrow internationally are indexed to the policy rate of interest of the U.S. (both for fresh and existing loans), a rise in the policy rate of interest by the U.S. Federal Reserve will increase the debt service making it onerous for these countries.

In either case (currency crisis and debt crisis), the U.S. government, through its intermediaries, may seek to further undermine the residual quantum of policy sovereignty of these countries.

However, a fiscal contraction in the U.S. is not the solution since this will also negatively impact the world economy by reducing the exports of the rest of the world to the U.S. In other words, both a fiscal expansion and a fiscal contraction in the U.S. will have different, but adverse consequences for the rest of the world.

A fundamental cause of this conundrum is the decreasing role of the U.S. economy as both a producer and source of demand in the world economy while it remains more significant in the realm of international finance. This calls for the rest of the world to work towards an alternative international financial architecture.

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