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Source: NCB Capital

Is inflation on its way back in the Gulf?

Inflationary pressures, which quickly rose to unprecedented levels in 2007–2008, appear to be reasserting themselves once again in the Gulf. While the real estate crash resulted in nearzero inflation in the UAE, September saw the first month-on-month increase in consumer price inflation in Saudi Arabia since the onset of the economic crisis. Once again, a combination of declining US Dollar and increasing oil price provided the backdrop to these pressures. This time around, however, the difference is that the basic level of inflationary expectations appears to be far higher than in 2005–2006. The main concern of GCC policymakers in the face of this risk is their relatively limited room for maneuver due to the Dollar pegs and the substantial government involvement in infrastructure projects.

Inflation is a recent phenomenon in the Gulf region whose economies had a remarkably long and consistent history of relative price stability until a sharp paradigm shift that started around the middle of this decade. The track record is all the more remarkable in view of the sharp volatility that oil price swings occasionally caused in other macroeconomic variables. However, the extraordinary oil-driven boom since 2003 not only increased the overall liquidity levels in the GCC economies but also fueled a remarkably robust and broad-based take-off in economic activity. Financial sector liberalization, along with the increasing openness to foreign financial flows, further boosted the liquidity situation.

The pick-up in inflation posed a major challenge to policy makers. It quickly revealed the limitations of the region’s Dollar pegs, once seen as a source of stability, at a time when the basic economic health and performance of the GCC fundamentally diverged from that of the US. Especially after the onset of the credit crunch, when oil prices still continued to rise, the regional economies were effectively deprived of the option of monetary tightening as the US Federal Reserve began to reduce rates in response to domestic problems. The Gulf central banks in some cases dragged their feet, but ultimately typically echoed the Fed’s position. Other efforts to reduce the amount of money in circulation included higher reserve requirements. In some instances, prudential regulation had the effect of quelling speculation and price pressures in individual sectors.

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