Columns - The Sunday Times Economic Analysis

Great expectations on controlling inflation

By the Economist

The decline in prices of oil has raised hopes of bringing down inflation to a single digit level from its current level of over 20 per cent. If this could be achieved next year there would be good reason to expect an impetus to economic growth. The lates figures on inflation too have given credence to an expectation of lower rates of inflation. According to the latest statistics released by the Central Bank, the rate of inflation decelerated to 24.9 per cent in August 2008 from 26.6 per cent in July, 2008.

What has to be recognized is that this is still a very high rate of inflation. The Bank also notes that the annual average rate of inflation increased from 21.9 per cent to 22.6 per cent between the two months owing to the cumulative effects of the increase in the Index during the preceding 12 months. The Central Bank predicts that the abatement of inflation which began in July, 2008 is expected to continue further during the remaining months of the year.

This is a much desired outcome that would assist economic activity. The Central bank takes credit for this abatement of inflation asserting that this deceleration in prices is due to the tight monetary policy stance adopted by the Central Bank, as well as to the increase in domestic food production coupled with the moderation of world commodity prices due to improvement in supply. Whether it was the tight monetary policies or the other improvements in supply that resulted in the deceleration would remain a debatable issue, but such controversy hardly focuses on the most pertinent issues. It is most likely a combined effect of a reduction in the rise in import prices of essentials, particularly oil and the increased production of domestically produced foods that would have had an effect on a degree of stability of prices.

Controlling inflation is vital to ensure economic growth and the current lack of confidence in the economy is mostly due to the high rate of inflation. Inflation is however a sign of deeper problems in economic management. Therefore the oil price decrease alone is not likely to bring down inflation. What can be expected at most is that one of the important factors that generated inflation may have lesser influence in prices next year. The oil price hike was an important influence on the high inflation but by no means the only factor. Therefore for the real control of inflation there is a need to take other measures such as control of public expenditure and selective monetary policies.

Controlling inflation is no easy task. Once inflation has reached high levels there is a tendency for prices of goods and services to feed on one another. This is due to the fact that when prices of certain commodities rise, especially prices of basic consumption, these trigger off increases in prices of other commodities and then of wages that in turn raise demand and increase prices. This is why inflation is often described as a spiralling phenomenon. Therefore even if oil prices do not increase further, the ripple effects it has created will continue to feed the spiralling of prices. There is also a tendency for prices that have risen to remain at their levels even though there may be a reduction in costs. This is a well recognised price behaviour that is called the “Ratchet Effect”. In the case of prices, what goes up do not necessarily come down. In fact the deceleration in the rate of inflation does not mean that prices are coming down. It simply means that prices are rising at a lower rate of increase.

Although the rate of inflation has declined, the level of inflation continues to be very high and well above the rates of inflation of our neighbours and competitors for exports in international markets. The slowdown in industrial exports is a glaring indication that inflation is affecting exports adversely. In a highly trade dependent economy like Sri Lanka, inflation must be brought down to international levels of price increases. The slowing down of industrial exports is a sign of the impact of inflation on export competitiveness. An export import economy such as ours that is highly trade dependent can be seriously affected by inflation as it discourages exports and encourages imports. Exports become dearer in international markets while imports become relatively cheaper. This widens the trade deficit and strains the balance of payments. This is especially so when the exchange rate is kept stable and not depreciated to compensate for the relatively higher costs of production of exports.

The need to bring down the rate of inflation should be a paramount consideration of economic policy. The plain truth is that high rates of inflation affect economic growth, reduces employment and affects the livelihoods of a considerable proportion of the population adversely. This year’s likely lower rate of growth is mostly due to the high rate of inflation that has stifled growth. Economic growth is likely to decelerate further if inflation is not brought under control. The consequence of an economic downturn would be a loss of employment and incomes of the workforce. This may not be a once and for all effect but have lasting effects on employment and incomes. Economic growth could keep spiralling downwards while inflation spirals upwards. This is why combating inflation is a paramount concern. The fundamental truth is that inflation hurts economic growth as price stability is essential for long-term sustainable growth. Therefore the stabilisation of prices in an economy is an essential first step to achieving high economic growth. And fiscal prudence is at the essence of controlling inflation.

The abatement of inflation owing to the stability of oil prices alone would not control inflation. At the root of the Sri Lankan problem of inflation is the large public expenditure that does not result in an increase in consumable goods and services. Government expenditure on defence, servicing the debt, administration, pensions and salaries of public servants create a large fiscal deficit that is the underlying reason for the inflationary trends. As long as these remain high, the expectation of a breakthrough in inflation is mere rhetoric: hopes and expectations that are unlikely to be realised.

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