The high inflation that plagued the UAE before the financial crisis has been tamed, but the respite might be temporary. Inflation last year was 1.5 per cent, its lowest level since 2000, according to government figures. Sultan al Mansouri, the Minister of Economy, said in February he did not expect inflation this year to eclipse 2 per cent.
Last year's figures and similarly modest forecasts for the near future have been a welcome reprieve for a country that had previously wrestled with rates in the double digits: inflation in 2008 was 12.3 per cent; in 2007, the figure was 11.1 per cent, according to government statistics. But the UAE's affair with lower inflation could be brief, if long-term trends in the global economy play out as economists expect. Food prices, which climbed in 2007 and 2008, are up again, potentially giving impetus to inflation in the near term. The UN's global food price index rose by 18 per cent between February last year and the end of last month.
A more protracted rise in food prices could have a significant effect on overall prices in the Emirates, which imports almost all of its food. Any rise in housing costs, the largest single component of the UAE's inflation index, could also accelerate price rises. Rents and other housing costs drove the double-digit jumps of the index in 2007 and 2008. Yet few observers see a quick upturn in any of the Gulf's property markets, given an excess of apartments and villas on the market and a dim outlook on demand from investors.
"I don't think domestic demand in the GCC will be as strong as it used to be a couple years ago, like from 2003 to 2008, when it was overheating," says Garbis Iradian, an economist at the Institute of International Finance in Washington, the global association of financial institutions. The larger threat, though, may be monetary policies determined in the developed world to combat a prolonged downturn. They could have an inflationary spillover in the world's emerging markets, including the Gulf.
There is a growing consensus among economists that deflation, persistent downward pressure on the general level of prices, will be a main concern for central bankers in the developed economies such as the US and European nations in the coming years. As they unwind their enormous stimulus packages and cut government budgets to reduce deficits, the fear is that deflation could follow as lower government spending puts downward pressure on prices.
Having witnessed Japan's futile, decade-long battle with a self-reinforcing cycle of deflation, financial leaders across the developed world want to avoid such a scenario at all costs. They would much rather see worryingly high inflation, an economic phenomenon they have learned to control, than even a hint of deflation, a situation with murkier causes and fewer solutions. To stave off deflation, central bankers are likely to turn to the same tools they used to stimulate economies at the outset of the financial crisis: keeping benchmark interest rates low. By pulling that lever, banks pump money into their economies - when the rates the central banks charge are low, the commercial banks tend to borrow more - in the hope that consumers and companies will increase spending as a result.
When more money is chasing the same amount of goods and services, prices tend to go up. That may be a wise prescription for developed countries that want to avoid deflation while reversing low GDP growth or even declines. But for emerging markets with stronger growth prospects, it may be a bitter pill. The UAE and all other Gulf countries aside from Kuwait peg their currencies to the dollar, effectively importing the monetary policy of the US Federal Reserve. The pegs have been sensible, given that Gulf countries' main export and driver of economic activity, oil, is priced in the US currency. The pegs also let the region's central banks focus on policing the financial sector instead of spending time and money setting policy and defending their currencies. Arguably, though, the priorities of the American economic authorities could hardly be more divergent from those in the Gulf, where growth projections are on an upward trend and major fiscal restraint is unnecessary.
The IMF estimates the UAE's economy will grow by 1.3 per cent this year, followed by 3.1 per cent in the next. If the US adopts deflation-busting policies, the pegs could produce the opposite effect in the Gulf and other emerging countries such as China, which has pegged the yuan to the dollar since the middle of 2008. Instead of damping deflation, persistently low interest rates in the US could cause a return to inflation in the region.
There is a chance that lower interest rates in the US could stoke inflation in the Gulf, says Paul Gamble, an economist at Jadwa Investment in Saudi Arabia. Even so, he says it would probably take many months for such a situation to materialise. And if it does, a repeat of the high inflation rates of the boom times appears close to impossible. "Maybe second half of next year if rates still haven't moved, it might become a bit of an issue, but I don't think it will go back to where it was a couple of years ago," he says.
And many economists, Mr Gamble included, are sceptical that higher inflation will come back to haunt the Gulf. Tim Fox, the chief economist at Emirates NBD, says there were many more forces working against inflation than for it. The dollar has remained strong throughout the crisis, meaning the Gulf's pegged currencies can buy more goods from Europe - the source of about 30 per cent of the region's imports - more cheaply. Second, low interest rates in the US are not translating into low rates in the Gulf because banks are bringing in money through local deposits instead of borrowing on international markets. Property prices, too, are not going up.
"I don't buy this line that the rest of the world is deflating and the emerging markets are inflating and somehow we're going to see a lot of inflation here," says John Sfakianakis, an economist at Banque Saudi Fransi. " Inflation is going to be, if anything, benign. Next year it will increase, but it's not going to be alarming at all." The IMF forecasts 2.2 per cent inflation this year in the UAE. Its projection for next year is a relatively modest 3 per cent.
Leaders and economists are hoping that rosy outlook does not change, even if the threat of a double-dip recession materialises in the developed world and central banks decide to keep monetary policies loose. afitch@thenational.ae
