By Sameer Sharma
Just on 15 June, and more than six months into its new flexible inflation targeting regime, the Monetary Policy Committee (MPC) of the Bank of Mauritius finally met to decide on the appropriate monetary policy stance of the central bank and left the key policy rate unchanged at 4.5 percent per annum. The brief monetary policy statement which followed had the MPC take credit for the base effect driven drop in year on year and core inflation which had already peaked in March 2023 and had nothing to do with them. The statement was dovish on the inflation outlook and more upbeat on both local and global growth prospects.
An unchanged stance was not surprising given the level of fiscal dominance over the central bank and given the increasing reliance on draining the foreign exchange market of liquidity via a moderate form of capital controls in order to significantly slow the speed of rupee depreciation. With public debt at close to half a trillion rupees, with the present value of unfunded liabilities on both the Basic Retirement Pension and state related defined benefits plans at more than 300 billion rupees (using the ten-year bond as a discount rate) and with private debt at more than 451 billion rupees (including household debt of 149 billion rupees), inflation is a key factor when it comes to deflating the real value of the debt and saving Mauritius from a credit downgrade.
The Mauritian government not only relies on inflation to bloat its revenues versus traditional taxation, but it also needs inflation in order to fund its liabilities. Given the correlation between inflation and land and property assets locally over the longer term, the private sector is also in on the decision. Was this the right decision and what could the consequences be?
More demand destruction may be needed
In order to assess this decision, one must first focus on the assumptions made by the Bank of Mauritius. When it comes to the global growth outlook, the Chinese economy is beginning to slow again given de-globalization, the continued balkanization of global supply chains and China’s own debt fuelled property market woes. The US economy remains more resilient given strong corporate balance sheets and tight labour markets which continue to translate into strong consumer spending despite falling consumer confidence.
However, while long term inflation expectations in the US remain well anchored, services inflation remains high and as base effects fade, the tightness in labour markets and supply chain bottlenecks will keep inflation moderately higher than the Fed’s comfort zone for longer and until at least late 2024. The real interest on the Fed funds rate is already at 3 per cent, which is above US potential GDP growth when taking expected inflation into account with real rates needing to remain tighter for longer in order to slow down the economy more and allow the Fed to meet its target.
Demand must slow further in order to meet constrained supply. Corporate profits are beginning to decline now on aggregate, and layoffs, which will finally trigger this long-awaited US recession, are coming next. The delay in these recession inducing dynamics is likely why core inflation has remained so stubborn. The 2023 US recession is likely to occur early next year, and markets are only likely to reprice this by September. The first US interest rate cuts will only occur by the middle of next year at best as recession dynamics take their toll.
The European economy is on its part already in a technical recession with two straight quarters of slightly negative growth. Both consumer spending and investment continued to decline during the same period. Inflation remains too high with real interest rates in Europe remaining near zero to negative. More demand destruction may be needed in order to meet constrained supply via some more tightening and keeping rates on hold until the end of 2024 while the US begins to cut earlier.
Inflation expectations in Mauritius remain loosely anchored
We are in a new normal of heightened market and macro volatility, and central banks will no longer be able to come to the rescue as they did before. The Bank of Mauritius uses Purchasing Managers’ Index data as evidence for a recovery in global growth, but it is again missing the plot. It is also ignoring the persistent nature of global inflation dynamics.
In March 2023, Statistics Mauritius predicted a 5 percent rate of growth for the economy and a mere 3 percent increase for the deflator, which was unrealistic. The real growth number was moderately overstated while the deflator number was understated. Three months later, the Ministry of Finance put out a very optimistic and unrealistic real growth estimate which is divorced from that of Statistics Mauritius, even when we adjust for calendar year effects. Given the inflation bias of the budget, the deflator on its part was forecast to stand at more than 9 per cent for the financial year. While that deflator number may seem too high, the Bank of Mauritius came out with a very different and significantly Consumer Price Index (CPI) forecast for 2024.
Real interest rates in Mauritius remain negative and cannot be defined as tight.
Now the GDP deflator is a broader and more complicated measure of inflation to calculate and should typically be moderately lower than inflation as measured by the more narrowly defined CPI basket. The gap between the BoM inflation forecast and the Ministry of Finance deflator forecast is significantly higher than what can be deemed realistic. The Monetary Policy Committee makes no mention of the budget and its deflator forecast.
It should also be noted here that the current CPI basket weights are still based on the 2017 Household Budget Survey with the weights from the 2022 survey not being made public yet. Given what has happened over the past 6 years, we would expect the current level of inflation to be moderately understating actual inflation itself. We should also not be surprised by the base effect induced drop in core and year-on-year inflation. Looking at the latest inflation expectations survey conducted by the Bank of Mauritius itself, one-year ahead expectations remain above 8 percent while five-year ahead expectations stood at a very high 6 percent.
Hence, inflation expectations in Mauritius remain loosely anchored and well above the BoMs upper bound target. In sum, not only do the forecasts of different bodies contradict themselves or not take budget factors into account properly, but the market is pricing higher levels of inflation versus the BoM itself.
No long-term trade-off between growth and inflation
When it comes to growth, the potential real growth rate of the Mauritian economy is in the low 3 percent range, and the economy is already showing signs of overheating with tight labour market conditions and still high core inflation rates. The base effect induced impact on core inflation will also fade away early next year, and both year-on-year and core inflation will then move up to between 4.8 and 6.5 percent after briefly falling to below 4 percent during the first quarter of 2024.
Given the extent of the expected output gap made worse by the budget and given market expectations of inflation one year ahead, real interest rates in Mauritius remain negative and cannot be defined as tight. In fact, the stance is very loose and applying the adjusted Taylor rule equation as published in the paper entitled “Towards Full-Fledged Inflation Targeting Monetary Policy Regime in Mauritius” (Ashwin Madhou, Tayushma Sewak, Imad Moosa, Vikash Ramiah and Florian Gerth), the key policy rate should currently be above 6 percent.
However, given complete fiscal dominance fuelled by the need to keep on pumping the debt fuelled consumption model along, real rates in Mauritius will remain negative for longer, which will force the Bank of Mauritius to maintain stronger capital controls in order to offset the budget impact on the current account deficit. The lack of credibility of the BoM however, when coupled with the need to deflate the real value of debt, keep a Moody’s rating downgrade at bay (without reviewing a broken and unfair tax system), and populist pension spending will keep inflation well above a required level of 3 percent over the medium term, a level required to maintain external competitiveness.
There is no long-term trade-off between growth and inflation. Predictable and low levels of inflation are good for investment and growth, which is why other central banks do not mind short-term pain for longer term gain. This is unfortunately not the Mauritian approach.