Inflation is price of strong growth

Given the divergence in economic growth between the Gulf countries and the US, any counter cyclical monetary policy will be difficult to implement and its effect will be minimal.

Raising the exchange value of the Gulf currencies vis-a-vis the dollar to combat inflation will not be effective either. The emphasis should be more on fiscal policy.

During most of the 1980s and 1990s when oil revenues were generally subdued, counter cyclical fiscal polices were put in place, with deficits becoming a regular feature of government budgets, in order to boost economic activities. In a similar manner, counter cyclical fiscal policy should be put in place during the current boom period to help dampen inflationary pressures. Wages and other current expenditures should grow in a measured way and the implementation of large infrastructural projects should be implemented over a longer time frame.

Overheating and inflationary expectations need to be managed because if left unchecked, they could challenge the sustainability of the GCC business model and would have negative economic and welfare repercussions. Inflation is a form of taxation that can be imposed without legislation, and because it is regressive (ie it hits the poor more than the rich), it could lead to rising income inequality and unwarranted social dissatisfaction. Higher wages intended to compensate for inflation would sooner or later feed into higher prices, leading to the loss of competitiveness and the risk of hard landing later on.

Overheating

Domestic demand in the region is being fuelled by strong government expenditures, backed by high oil revenues, and a confident private sector embarking on a strategy of growth and expansion. This is compounded by excessive growth in domestic liquidity due partly to high levels of bank lending. There are overheating pressures on the supply side as well, with rising rents due to tight housing and property markets, higher prices of food and rising cost of production due to the surge in the price of imported material, manpower and associated logistics. Supply bottlenecks across various infrastructural sectors also add to the supply push inflation.

Because countries of the region have their currencies pegged to the dollar, they cannot implement aggressive counter cyclical monetary policies. They were not able to lower domestic interest rates when they needed to do so in the 1980s while dollar rates were rising, nor are they able to raise rates now. Kuwait whose dinar is pegged to a basket of currencies and where lending rates were kept relatively high, saw its currency surging by six per cent on the dollar last year.

Inflation in the region is more of a cyclical rather than structural phenomenon. Policy makers should avoid the temptation of adopting long term polices (such as delinking their currencies from the dollar after maintaining a credible fixed peg for more than 23 years) while addressing a short term cyclical problem. Besides, if domestic currencies are revalued under the pressure of speculation, it would encourage more speculation down the road.

Inflationary pressures are likely to subside when the huge supply of residential units currently under construction come to the market and governments of the region start to follow a more measured and restrained fiscal policy. The perception that real estate prices worldwide had peaked may well discourage additional speculative buying in the region's property markets.

There are certain measures on the monetary side that governments here can and have been doing to stop inflation from running out of control. These include higher required reserve ratio to force banks to lend less, regular issuance of bonds, sukuk and CDs by governments of the region to help soak up excess liquidity, and widening the gap between lending rates and deposit rates.

Other measures included putting a cap on annual rent increases, allowing for compensatory wage increases to be in line with official inflation rates, providing food subsidies and low cost housing for the poor, and extending the mortgage duration from the existing average of 10 years to 25 or 30 years as is the case in several other markets. The increase in the duration will result in less monthly debt burdens and less rent.

To conclude, higher prices will continue to be the inevitable consequence of strong government expenditures backed by rising oil revenues and exacerbated by excessive growth in domestic liquidity. Inflation is the price that businesses and consumers will have to pay while enjoying unprecedented boom economic conditions.

Counter cyclical fiscal policy is more effective to dampen inflationary pressures in the region than monetary or exchange rate polices. Not much could be done to deal with inflation caused by supply bottlenecks, we need to "wait it out " until more supply comes to the market.

- The writer is CEO of Deutsche Bank, Middle East and North Africa.