Resurgence Of Inflation And New Geopolitical Realities Redesigning Macroeconomic Policy – Speech


Remarks by Alfred Kammer, Director of the European Department, at the National Bank of the Republic of North Macedonia and Reinventing Bretton Woods Committee.

Good afternoon to everybody. 

Thank you, Governor Bezhoska, for the invitation to speak. This conference could not be more timely as Europe simultaneously grapples with firmly bending the inflation curve in the near-term and attempts to revive its growth engine in the medium term against the background of rising geopolitical risks.

Europe has weathered well an unprecedented series of shocks, the pandemic and the energy crisis triggered by Russia’s war in Ukraine. Severe downside scenarios were avoided. This is a big accomplishment! 

As the immediate economic effects of these shocks fade, a key policy priority for Europe is to focus on restoring price stability and securing strong and green growth. 

But achieving these goals is complicated by emerging headwinds: Geoeconomic fragmentation and the impact of climate change pose new challenges that compound Europe’s long-standing growth problems.

Moreover, for countries in the Western Balkans the convergence of income levels to those of advanced European economies has stalled for some time now. And the region is at risk of falling behind. But the future also offers opportunities—think of the many transformations taking place, the advance of electrical vehicles, artificial intelligence and near-shoring. But to succeed countries will need to position themselves well by implementing sound macroeconomic policies and undertaking reforms to strengthen productivity and improve the business environment.

Let me first outline the current economic setting and the near term outlook. 

We are projecting a “soft landing”. But both the domestic and external risks are tilted to the downside and the medium-term growth prospects are weak. 

Southern European countries this year generally fared better than average, in part reflecting the revival in the tourism sector during the summer. In contrast, economies that are more dependent on manufacturing and other energy intensive sectors, such as Germany and some Central, Eastern and Southeastern European countries, have been hit hard.

There are indications that activity in the third quarter has slowed further and that the downward momentum is spreading to services. 

The lagged effects of real income losses from high inflation and tighter macroeconomic policies will be shaping the outlook. There is little support expected from the global level. The effects of stronger growth in the US will largely be offset by the growth slowdown in China, although the magnitude of the impact could vary across countries. 

In short, the recovery from the double shock remains sluggish and the medium-term outlook remains clouded.

The good news is that headline inflation has fallen in most of Europe and the Western Balkans. This largely reflects two factors: falling energy prices and the unwinding of supply chain bottlenecks. However, the recent spike in oil prices underscores the risks to the inflation trajectory. 

In addition, underlying core inflation rates have only begun to moderate but remain stubbornly high—often still 2-3 percentage points above policy targets. 

Labor markets remain tight overall with some softening. Employment now stands above its pre-pandemic level in both advanced and emerging European economies.

The tight labor market and high inflation have led to an acceleration in nominal wage growth across Europe, especially in Central, Eastern and Southeastern European countries.

In the Western Balkans, rising nominal wage growth is contributing to already-high inflation. Worryingly, growth of nominal wages in excess of productivity and inflation has started to drive up unit labor costs. This can lead to sustained wage-price passthrough and risks decreasing the overall competitiveness of Western Balkan economies.

Now let me move to the medium-term growth outlook. 

In the Western Balkans, the speed of convergence with advanced economies in output-per-capita has slowed over the last decade. In North Macedonia, for example, output-per-capita grew from around 27 percent of the EU average in 2000 to 37 percent in 2010 but then increased by only 1 percentage point to 38 percent in 2019. 

So, what is driving this slowdown in convergence? 

In general, reforms have stalled, and growth engines appear exhausted. 

A key factor is a still-large investment gap in infrastructure and human capital. In North Macedonia the capital-output ratio has been declining despite steady productivity growth and increasing labor force participation. Other Western Balkan economies displayed a similar slowing of output-per-capita convergence, driven, though, more by a slowdown in productivity growth. 

Public infrastructure is substantially underdeveloped in the Western Balkans, on average less than 20 percent of older EU member states. As an example, North Macedonia has half the railway and motorway density of the EU average, half the installed power generation capacity, 30-40 percent lower phone line, cellular, and broadband subscriptions, and underinvestment in human capital and innovation.

Another increasingly important factor is an insufficient labor supply. Young and educated workers continue to leave the Western Balkans for opportunities elsewhere. The latest census figures of 2021 indicate that at least 10 percent of the North Macedonian population has left the country over the last two decades.

This type of migration has a disproportionally negative effect on GDP per capita as migrants tend to be more educated and younger. A recent IMF study showed that that in the short run a 1 percentage point increase in emigration leads to a 3 percent decrease in the number of firms—with a similar effect on GDP. 

These domestic challenges are compounded by rising external risks. 

Global fragmentation continues to be a disruptive force and a driver of downside risks. 

The pandemic and Russia’s war in Ukraine, have disrupted commodity markets and global supply chains, raising concerns about national security and supply-chain resilience. 

In response, many countries, even those that once championed free trade are turning to inward-looking policies to isolate from rivals and secure strategic supplies of goods, from computer chips and semi-conductors to rare earth minerals vital for clean technologies for the green transition.

Trade restrictions have increased sharply, by 3-fold last year compared to the pre-pandemic period. FDI is also increasingly concentrated among geopolitically aligned countries.

We have also observed a surge of protectionist and discriminatory measures, such as local content requirements in industrial support programs and export restrictions targeting countries that are not regional trade partners. And policymakers are increasingly enacting measures to move production back home or to politically aligned countries. 

The global economic costs of fragmentation are not trivial. Estimates of the long-term output losses from restricting the international flow of goods and services, finance, and technology range from 0.2 to 12 percent of global GDP depending on the assumptions and scenarios. 

Over the long run, trade fragmentation alone—that is, the splintering of countries into blocks that trade exclusively with each other—could reduce annual global GDP by up to 7 percent, or 7 trillion euros, the equivalent of the combined GDPs of France and Germany. 

Costs will vary by country. While some countries could benefit—reorientation of trade and supply chains may create localized growth opportunities—most countries will lose. 

And these costs are just of trade fragmentation, before we add the costs of climate change and weather events, which we have seen this summer from Canada, Hawaii, and Hong Kong to Greece and Libya.

So what can the countries in the region do to succeed in this new environment, both in terms of near-term and medium-term policy priorities? 

The overarching near-term priority is to restore price stability. Decisively tackling inflation now will also help set the basis for stronger medium-term growth. 

Monetary policy needs to be kept in unambiguously tight territory until underlying inflationary pressures abate. Experience from past inflation episodes cautions against easing too early. Predictions of speedy disinflation can prove optimistic as a new IMF paper shows. Easing too soon would be costly. 

Fighting inflation also needs the support of fiscal policy. Fiscal authorities should help fight inflation by containing current spending—not by cutting capital spending. 

For the medium-term there is a need to reinvigorate engines of growth that are at risk of being exhausted. Strengthening governance and improving the business environment will be key to boost investment, attract FDI and keep high-skilled labor. 

Strengthening both institutions and macro-fundamentals is critical, including for successfully implementing reforms. Weaker institutions make it easier for vested interests to block reform efforts; while sound economic policies complement and make reforms more palatable. 

Several central banks in the region have been under strain from political interference. Central banks need to be able to fulfill their mandates on inflation and for this independence is essential.

A stronger business climate is needed for domestic investors. To capitalize on FDI, policymakers should help create conditions that create an ecosystem of local suppliers, small and medium-size enterprises to manufacture inputs for larger foreign companies. Here, strengthening governance via better anti-corruption frameworks, and aligning regulation with international best practices would help. 

Investment is needed to facilitate the transition to renewable energy and green technology and to modernize transport and telecom infrastructure. Better infrastructure would help raise productivity and improve attractiveness for foreign investment. This would support capital accumulation and help close the gap with Western European economies.

Finally, governments should decarbonize their energy sectors. Energy-intensive economic sectors will be increasingly uncompetitive with the EU’s Carbon Border Adjustment Mechanism in place as soon as 2026. Policymakers should introduce carbon pricing and allow electricity prices to rise, using the resulting revenues to finance a transition to renewables.

To conclude. 

If there is one key message to leave with you, it is that policies will matter.. 

With the right policy mix, Western Balkans economies can secure low inflation and increase the long-term growth trajectory.

At the macroeconomic level this means keep a tight monetary stance and do not ease prematurely, and fiscal policy should help with disinflation.

Structural policies also play an important role:

Get the investment climate right: By strengthening governance via better anti-corruption frameworks countries can durably attract investment domestically and from abroad.

Success in the Western Balkans will require difficult reforms now that will pay off later. At the same time the commitment to sound institutional frameworks needs to be maintained. This is an investment worth making—and one that the IMF stands ready to support.

Thank you.

Alfred Kammer

Alfred Kammer is the Director of the European Department at the International Monetary Fund since August 2020. In this capacity, he oversees the IMF’s work with Europe.

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