Managing inflation in the UAE is a matter of matching supply and demand

The UAE's tools to manage inflation are limited because the Central Bank must defer to the US Federal Reserve when setting the country's interest rate.

They call it the monetary policy “trilemma” of free capital flows, an independent interest rate, and a fixed exchange rate. A government can pick at most two out of three.

It is why the UAE cannot use interest rates to tackle inflation, which last month topped 6.1 per cent in Abu Dhabi and 4.9 per cent countrywide.

If, as the UAE government does, you want a fixed exchange rate and free capital flows, then economic logic dictates that you cannot set your own interest rates. Suppose country X (the UAE) has a stable exchange rate pegged to the currency of country Y (the US), and free capital flows – and that country X raises its interest rate independently of country Y. That attracts hot money to country X from country Y, as some investors who were investing in country Y now find that they get a higher rate of return in country X.

This new demand for investment puts pressure on the exchange rate as investors seek to buy country X’s currency to do business. The exchange rate appreciates, resulting in country X not having a stable exchange rate much longer. That, in short, is why the UAE’s Central Bank will likely to raise the UAE’s interest rate as soon as the Fed does – to do otherwise would threaten the dirham’s peg to the dollar. But it means that interest rates in the UAE cannot be used to reduce or stoke domestic inflation.

In Britain and the United States, the interest rate can be used to choke off inflation by reducing investment and consumption. Consumer debt becomes more expensive and less attractive, while the number of projects that have a positive net present value in a higher interest rate environment falls.

So what tools does the UAE have to reduce inflation?

Because the state owns major property developers and builds and runs schools and hospitals, it has a role in setting supply equal to demand in three sectors where supply has fallen short, with inflationary consequences.

Housing shortages in Abu Dhabi have pushed up prices – Aldar is best-placed to address that. So too with schooling – the Abu Dhabi Education Council can open more schools. That is why the government has to plan how much capacity it wants in education, real estate and health care years in advance.

The UAE government has at times also opted for the cruder method of price controls – in essence, demanding that prices for a certain asset class remain low.

In Abu Dhabi, this took the form of the rent cap – a set of regulations that kept annual rental inflation below 5 per cent by allowing rents to rise by only that much per year.

During Ramadan, too, the government stipulates that food prices on essential supplies are to remain static or even lowered. Heavy fines are promised to those who breach the law. The government can also alter reserve requirements at banks.

By demanding higher levels of cash and high-quality capital to be kept on banks’ balance sheets, the government can reduce the amount of lending activity to the overall economy, slowing growth and reducing prices.

This is similar to increasing the interest rate – it increases the minimum rate of return required for a bank to invest, by increasing the marginal cost of capital.

None of these tools are quite as powerful as setting interest rates, which affect every company and consumer in the country at once.

“Because the UAE is quite an open economy that doesn’t have control over its monetary policy, it doesn’t have many levers with which it can reduce inflation,” said Jason Tuvey, an emerging-markets economist at Capital Economics.

“But I’m sure that if the authorities got really concerned about inflation, they could reintroduce the rent cap or increase subsidies again.”

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