The Egyptian Center for Economic studies (ECES) prepared a study on recent inflation dynamics in Egypt with the objective of assessing whether there are structural factors behind the rise in inflation since 2003. Specifically, we uncover the role of two significant determinants of long-running inflation dynamics, namely excessive monetary growth and a rise in the intensity of relative price variability.
These two variables are shown to play a key role in explaining inflation developments over the period from January 2000 to October 2018 after controlling for the impact of exchange rate devaluation, energy price liberalisation, adverse supply-side shocks, and movements in international commodity prices.
While the latter group of variables was influential in triggering inflation waves over the short to medium term, our empirical results show that excessive monetary growth and increased variability in relative prices are the main drivers behind the rise in inflation. The policy implications of our findings point to the immediate need to curb excess money growth in the economy, and also the pertinence of treating the issue of the price pf liberalisation using a holistic long-running plan as opposed to the historically adopted piecemeal approach.
Inflation Developments in Egypt (January 2000 – October 2018)
Specifically, our work sheds light on two salient features of the Egyptian economy that we argue have been instrumental in driving inflation dynamics in recent years. The first is intense variability in relative prices, and the second is excessive growth in money supply.
In comparison to a large cross section of countries, Egypt appears in the top ranks with regard to these two variables. Using scatter plots of inflation against relative price variability (RPV) and the differential between nominal money supply growth and real GDP growth (M2-GDP growth differential) for 84 countries, two preliminary conclusions emerge: both variables show strong correlation with inflation, and Egypt appears as one of the outlier countries in both charts showing excessive levels of RPV and monetary growth.
Relative Price Variability and Excessive Monetary Growth: Cross-Country
It is undoubtedly the case that other factors have been at play during the last two decades which acted as a catalyst for the increase in inflation. For instance, Egypt has witnessed successive devaluations in the earlier part of the sample during 2002-2003, and also a significant devaluation in November 2016 accompanied by a policy announcement to float the currency. In addition, the prices of energy-related goods and other goods with administered prices have been hiked a few times, coupled with sector-specific supply-side shocks. However, and as shown in the empirical analysis, these factors only had a transitory impact on inflation and the rise in inflation is largely driven by intense RPV and excessive monetary growth.
An extensive literature has documented the strong association between inflation and the variability in relative prices. Significant adjustments in relative prices tend to occur in a high inflation environment. However, RPV itself is a realisation of both the structural features of the economy as well as the tendency to distort price signals through administered prices.
Historically and until this day, administered prices are prevalent in Egypt. The government sector enjoys a heavy presence in the economy, and various goods and services are offered by public entities at administered prices which are not necessarily at par with market-based prices, and are often kept unchanged for prolonged periods of time. The historical predominance of administered pricing is a product of the socialist era in the 1960s, and was maintained since the economic liberalisation in 1974 to protect the poor from the adverse effects of inflation.
However, over the years, and due to the piecemeal approach to price liberalisation, this led
to severe distortions in the structure of relative prices in Egypt.
In addition to its effects on inflation, RPV impacts resource allocation, the level of employment and output, as well as the informational role of prices in the economy “Hayek (1945), Alchian (1969), and Fischer (1981)”. Keynes (1924) emphasises the extent that RPV can negatively affect specialisation in the economy, while Ball and Romer (2003) argue that relative prices are the tools which enable the “invisible hand” to guide efficient resource allocation. As RPV increases, the reliability of the information signals transmitted by prices diminishes in importance and, in response, search activities increase. This, in turn, leads to more time and resources being consumed in decision making “Blejer and Leiderman (1980), Ball and Romer (2003), and Tommasi (1994)”.
With regard to excessive monetary growth, both theoretical and empirical work has shown that fiscal dominance plays a primary role in such an outcome. In Egypt’s recent history, there is a notably high correlation between the government’s budget deficit and excessive monetary growth, which points to the potential prevalence of a monetary policy regime that is accommodative of the fiscal policy stance at the expense of high and volatile inflation.
The significant effect of excessive monetary growth on the rise in trend inflation is not disconnected from important considerations regarding the conduct of monetary policy in Egypt. Historically, it has generally been difficult to ascertain the nature of Egypt’s monetary policy regime.
Given prolonged periods with a fixed exchange rate, the latter has become a de facto nominal anchor.
However, an inconsistent mix of fiscal and monetary policies has led to two severe currency crises in 2002-2003 and 2015-2016. In the aftermath of both crises, the Central Bank of Egypt (CBE) announced the floatation of the currency only to be followed by periods of uncharacteristically low exchange rate volatility.
The findings of the study indicate that while inflation has been partly driven by transitory
factors in the short run, such as exchange rate devaluations and other supply-side shocks, the
rising trend in inflation in recent years was primarily due to structural and institutional factors,
namely intense relative price variability and excess money growth. The empirical robustness
of the estimated model as well as its superior forecast performance lend further support to this
The policy implications of “Egyptian Center for Economic Studies” findings are centred on the immediate need to tackle the issue of price liberalisation using a holistic long running plan, in addition to the pertinence of curbing excess money growth in the economy. With regard to the first dimension, Egypt needs a comprehensive plan for price liberalisation as opposed to the historically-adopted piecemeal approach. With the prevalence of a distorted structure of relative prices due to the high incidence of administered prices in the economy, it is inevitable that relative price variability will remain a strong driver of inflation in the years to come.
However, an adequately-designed strategy can ameliorate some of the negative impacts of price liberalisation.
This requires a study of the optimal sequencing of price increases, where it may be better to opt for continuous small increases above the rate of inflation (over a longer period of time) rather than the current practice of occasional large price increases.
In parallel, it is absolutely necessary to introduce fiscal rules in Egypt. Fiscal rules are part and parcel of an overall institutional setup that is needed to rid the system of fiscal dominance, enhance the independence of the central bank, and improve long-running inflation outcomes.
In addition to fiscal rules, there is also need for an independent body to monitor and review fiscal operations and public finances within a medium-term framework.
Finally, the central bank needs to devise a strategy with a clear timeline for the adoption of full-fledged inflation targeting. With the announced floatation of the exchange rate in November 2016, it is high time for the central bank to enhance its communication with the public to introduce inflation targeting as an alternative monetary policy framework.
The transition to inflation targeting will help anchor inflation expectations around the announced
target, thereby leading to a gradual reduction in the rate of inflation as well as its volatility.