UAE Monetary Policy, Wages and Output Growth " article "

UAE Monetary Policy, Wages and Output Growth Dr Tarek Coury / 2 August 2009 Interesting news about the current rate of inflation in the UAE and the rate of domestic money growth sheds some light on the relative health of the UAE economy. First, we’ve seen a fall in prices in June, driven by housing and food and beverages. These account for about 44 per cent of the composition of CPI and therefore impact inflation in a substantial way. On the other hand, data on M3, a measure of broad domestic money, shows that the rate of growth of money supply in the UAE has fallen to its lowest level since 2001. M3 has seen growth of about 9 per cent on an annualised basis so far this year; this compares to 22 per cent for last year and 37 per cent in 2007. Is this recent data consistent with a recovery or a continued contraction? The data on inflation is relatively straightforward to interpret: the deflationary episode is being driven by the fall in equity prices which, in turn, was caused by a mass sell-off of properties and stocks. This is causing a negative wealth effect which is making aggregate demand fall. In an economy where the currency is allowed to float, the resulting fall in demand for the domestic currency would cause a fall in the nominal value of the dirham. But the UAE Central Bank follows a policy of pegging the dirham to the dollar. As a result, any fall in currency demand has to be met by a fall in the supply of the currency to keep the nominal exchange rate stable. This is reflected in the data as slowing money growth rates. So the current data suggests that the economy is continuing to adjust to the fall in domestic aggregate demand. Interestingly, the current monetary regime causes output to contract by more than it would have under other exchange rate mechanisms. The Central Bank has maintained the peg to the dollar since the late 1970s but the price of gaining monetary credibility is an accentuated business cycle. The economy, however, has a self-correcting mechanism to deal with the current downward trend in the form the private sector. As inflation slows, so do money wages that firms pay their workers; they do this to keep their profits up. Because the economy is currently operating under its potential, the fall in money wages may be more substantial than the associated fall in prices. The net effect is to eventually push up the competitiveness of the UAE economy: as prices fall, the real value of the currency drops, driving up demand for domestic goods and services, like tourism. This self-correcting mechanism will therefore be associated with slow growth of inflation, and even a potential prolonged deflationary episode. It will, however, be associated with increased money growth rates and a recovery in output growth. Domestic output is likely to recover once firms trim their costs: In the UAE, the process of cutting input costs may be substantially faster than in other countries. Indeed, the competitive nature of the labour market, and the high turnover rate of the foreign workforce is likely to ensure that domestic money wages adjust much faster than in economies where labour markets are subject to various frictions. On a final, (and I hope) positive note, it is unlikely that the UAE will experience the dreaded “deflationary trap” experienced by some economies in the past few decades. The Central Bank cannot control inflation as it uses its monetary instrument to control the nominal exchange rate. On the other hand, high inflation volatility is likely to persist. It has been with us for the past few decades precisely because of the current monetary arrangement. Inflation reflects the imported price of goods and services but also has a substantial self-fulfilling component. In economies where the Central Bank targets a rate of inflation credibly, the private sector uses inflation projections in wage bargaining. As a result, inflation ends up reflecting bargained wages. Because this self-fulfilling process of inflation adjustment is severely attenuated in the UAE, inflation dynamics tend to be fairly erratic as they have been since the early 1980s. This, in turn, has an effect on the level of investment in the UAE: investment decisions on the aggregate level are made according to the real rate of interest and as a result investment dynamics also tend to be volatile. This cost to economic performance is, on balance, well worth paying. Since, in the long-run, output reflects underlying productive capacity, a monetary policy of pegging the dirham to the dollar ensures that monetary disturbances are minimised. This policy is especially well-suited for an emerging, open economy like the UAE. (Dr Tarek Coury is an economist at the Dubai School of Government and the Harvard Kennedy School.) http://www.khaleejtimes.com/DisplayArticleNew.asp?section=business&xfile=data/business/2009/august/business_august21.xml