The central bank of Zimbabwe raised its policy rate by 80% to a new high of 200%. This increase comes as Russia’s invasion of Ukraine is driving up global commodity pricesexacerbating inflation in many countries around the world, including Zimbabwe.
The thought of Zimbabwe’s Finance Minister, Mthuli Ncube, is that an aggressive tightening of monetary policy is needed to counter these inflationary pressures. In Zimbabwe too, there has been an increase in the prices of imported food, fuel, fertilizers and other essentials.
This is why, according to the minister, inflation accelerated to 192% in June.
In fact, inflation was very high before Russia invaded Ukraine. From 2000, it rapidly increased from one figure to 114% in 2004, climbed even higher to 157% in 2008, then peaked at 558% in 2020.
There have long been two fundamental drivers of inflation in Zimbabwe. The first is monetary expansion which is not supported by economic growth. When there is more money in the economy than goods and services that can be purchased with it, its purchasing power drops and prices rise.
The second concerns what Zimbabweans now expect in terms of inflation. Expectations are generally anchored when the prices of goods and services are stable over time and consistent with what people expect to pay for them. In Zimbabwe, this is no longer the case – expectations have been de-anchored. This happens when prices differ significantly from what people expect. If they increase, it can have an inflationary effect by pushing up wages and the demand for goods and services. Rising wages and demand could in turn push prices even higher, making inflation expectations self-fulfilling.
An example of another country that has been gripped by hyperinflation and an unanchoring of expectations is Venezuela in 2017.
But Zimbabwe’s central bank’s decision to raise rates too aggressively carries risks. Higher rates could reduce production, while prices continue to rise as in the 1970s. These conditions are called stagflation.
This is worrying as growth in Zimbabwe and other African countries is already is expected to slow down over the next few years due to higher global inflation, tighter global financing conditions, over-indebtedness, further supply disruptions and increased risk of geo-economic fragmentation for the global economy.
After independence in 1980, Zimbabwe’s central bank managed to keep prices from spiraling out of control. During this decade, inflation fluctuated between 10% and 20%. The situation changed dramatically in the 1990s when the economy collapsed after the government introduced a land reform program.
This was intended to redistribute land from the white minority (who owned most of the country’s fertile farmland) to the majority black Zimbabweans who had been disenfranchised during the colonial period. But the program was poorly implemented and mostly benefited senior officials and those closely associated with them.
The result was a sharp drop in agricultural productionwhich had been an important source of exports, foreign currency and employment.
At the same time, tax revenues have fallen as the economy contracted, prompting the government to fund higher spending by printing money. Since this monetary expansion was not accompanied by greater economic growth, inflation accelerated rapidly.
In the 2000s, the inflation problem became so severe that Zimbabwe was caught in a crisis of hyperinflation which caused a sharp weakening of the local currency and triggered a deanchoring of inflation expectations.
Initially, the government tried to contain inflation by impose price controls. without much success. Instead, this move triggered widespread product shortages and fostered an underground economy where price controls were not applied.
The first episode of hyperinflation ended in 2009 when the government decided to replace the worthless Zimbabwean dollar with the US dollar. This decision stifled inflation until 2018, when a new local currency was introduced.
This new currency quickly triggered a second episode of hyperinflation. Confidence in the Zimbabwean dollar had been badly shaken by the previous episode of hyperinflation and the US dollar remained the preferred currency for households and businesses, even with the new local currency in circulation.
In addition, there were fears that the government might once again go back to printing money to finance a growing budget deficit. For these reasons, the new Zimbabwean dollar was not popular and its purchasing power quickly eroded, triggering a sharp price increase.
Inflation has peaked 255% in 2019, compared to a modest 11% in 2018. It accelerated further in 2020, peaking at 558% that year. It has since declined, but remained high nonetheless.
New measures announced by the Minister of Finance include the reintroduction of the US dollar, which will be used with the Zimbabwean dollar. This is the second time the government has taken this step. The first dates back to 2009, when the Zimbabwean dollar was abandoned after its value collapsed following the first episode of hyperinflation.
In addition, the central bank will introduce gold coins, which will serve as a store of value and can also be used as collateral and to complete transactions. In doing so, the central bank implicitly admits that the printed Zimbabwean dollar in circulation has failed to fulfill its role as a store of value and medium of exchange.
The cost of living crisis fueled by high inflation has already fueled numerous strikes by state employees. More recently, teachers and health workers went on strike to demand a pay rise.
The prospect that growing labor unrest will radiate into other sectors is great. Therefore, with higher inflation expectations now firmly entrenched, aggressive central bank policy tightening will most likely temper demand, while doing little to repair the persistently weak output capacity of the economy. economy.
If that happens, the more hawkish central bank response increases the risk of stagflation – the combination of faltering demand and accelerating prices. This increases the risk of the economy sliding into a recession.
The fundamental and long-standing drivers of inflationary pressures in Zimbabwe are loose monetary policy and unanchored inflation expectations, not the war in Ukraine, which currently commands the most attention from policymakers.
The central bank should therefore focus more on tackling the underlying drivers of inflation.
To limit monetary growth, he should start by abolishing the Zimbabwean dollar and legalizing the use of the US dollar as planned. This would help, as the US dollar provides a superior store of value and would force the government to wean itself off of money printing dependence.
Finally, strong and credible communication from the central bank plays a key role in anchoring Zimbabweans’ views on inflation. This is worth noting because Zimbabwe’s central bank has not maintained a strong record of keeping inflation low and stable for over a decade. Trust in the institution is low.