Business | Investment
UAE's tryst with Phillips Curve
Yesterday, I had an angry caller complaining that Gulf News has not done enough to highlight the rising cost of banking services in the country.
- By Babu Das Augustine, Banking Editor
- Published: 23:51 August 22, 2008
Yesterday, I had an angry caller complaining that Gulf News has not done enough to highlight the rising cost of banking services in the country.
I promised the gentleman that I would investigate. Apart from pacifying my reader, my promise was backed by a genuine interest to find out why the banks should jack up prices while they were earning decent margins.
As I wasn't looking for a run-of-the-mill explanation for this phenomenon, I called up a banker friend. He gave a very long explanation. In a nutshell he said that their expectations of the cost of doing business in the country are very high, and therefore require a new fee structure to offset that prospect.
Although it might sound a bit weird, expectations are indeed a major factor in the current price spiral. The huge growth in liquidity, supported by petrodollar monetisation and low interest rates, continues to exert demand pressures on the economy. In addition, the symptoms of a wage-inflation spiral in both the public and private sectors are also evident in the UAE.
While the federal and local governments were prompted to respond to inflationary pressures last year by increasing wages and subsidies to improve or maintain purchasing power, the private sector also had to respond via wage hikes to remain competitive in that light.
At the 'macro' level, clearly the main culprit behind rising prices is heightened economic activity. In most economies, periods of above-average inflation tend to be associated with above-average economic activity. In 1958, A.W Phillips, a New Zealand-born economist, put forward the theory famously known as the Phillips Curve suggesting a trade-off between inflation and unemployment (representing a low level of economic activity).
The experience of many countries in the past shows that the logic behind, and continuation of, that apparent relationship curve is valid only in the short term, and 'stagflation' (high inflation with low GDP growth) can be a long-term possibility instead.
Given the high composition of oil revenues in its GDP, theoretically a country like the UAE should be able to sustain high growth even in the face of high inflation over a longer period. But from the experience of across-the-board escalation in costs (prices), it is evident that any attempt to orchestrate permanently higher growth would only cause an upward spiral of inflation and inflation expectations.
A recent study by Lehman Brothers supports this argument. It said firms are forward-looking and set a path for their prices that takes into account the expected erosion in their real profitability due to inflation.
"Firms' inflation expectations, in turn, depend in large part on what policies they expect the monetary authorities to follow. Conditional on these expectations, firms set their prices as a mark-up over their expected marginal costs," says the study.
This approach would link the current rate of change in prices (inflation) in the UAE to expectations about the future rate of price changes.
That calls for forward-looking monetary and fiscal policies that can give the right direction to businesses in managing their expectations.
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