Corporate
affairs
On price stability and deflation
By Sunil Karunanayake
Delivering the monthly lecture at the Central Bank Centre for Studies
Dr Narendra Jadhav, Principal adviser and chief Economist Reserve
Bank of India chose an appropriate topic on" Challenges in
Achieving and Maintaining Price Stability in Developing Economies".
Undoubtedly
developing countries are at the moment on a tight rope walk with
repeated oil shocks (beginning from 1974 through 1979-80 1990 and
the present) and apparent negative effects of WTO measures. Calling
inflation as the most iniquitous tax on the poor Dr Jadhav clearly
asserted that price stability is not zero inflation but low positive
rate of inflation.
Inflation,
deflation and price stability are interrelated. Generally it is
largely believed that inflation is harmful, causes misallocation
of resources and adversely affects the poor while on the other hand
deflation though somewhat welcome at the onset too gives rise to
many issues depressing demand, rigid nominal wages, increasing labour
costs and reduced competitiveness. A noteworthy development during
the 1980's and the 1990's is that Central Banks all over the world
have been increasingly able to reduce inflation, the decline in
developing countries has been more significant showing a decline
from 56 % in the 1990's to 6 % in 2003.
The
performance in Sri Lanka is no different with single digit inflation
seen in recent times. Latin American countries famous for treble
digit inflation have now brought them down to the 10% range.
Advanced
industrialized countries have maintained inflation at 2 to 3%. Alan
Greenspan defines price stability as the rate of inflation that
is sufficiently low yet positive so that it has no major impact
on households and businesses. At the same time way back in 2002
Greenspan cautioned that latent deflationary measures are appropriately
addressed well in advance of them reaching problematic heights.
The
volatility of price creates uncertainty in economic decision-making,
rising prices fuel speculation and makes inroads into savings, and
monetary policy is the instrument to arrest this situation and direct
resources more efficiently.
A regime of rising prices does not promote savings and high inflation
also affects the exchange rate.
These
issues are more critical and politically sensitive to economies
like ours where 40% of the population is on income support schemes.
Taking a look at Sri Lanka one can be satisfied in the manner the
stock market has been performing with initial public issues recording
massive responses thus facilitating the capital formation and growth
within a low interest regime backed by curtailed inflation.
Price
stability and growth must co exist. Deflation too has come in to
focus with the experience in the Japanese economy reflecting weak
growth in a sustained deflationary environment. These have given
rise to high unemployment, falling nominal wages, interest rate
declines, lower equity prices and rising public debt.
According
to the IMF there are two types of deflation, firstly the type what
Canada, Norway and Sweden experienced in the late eighties following
lack of demand and a general decline in activity. The other originates
from major supply side improvements as experienced in China, however
this environment promotes economic activity and asset prices could
move up.
Both
types of deflation leads to a series of issues for policy makers,
redistribution of income from high spenders to low spenders thus
depressing demand and ultimately affecting activity, increasing
real labour costs and reduces competitiveness.
The
Monetary Board of Sri Lanka is at times being criticized for keeping
the interest rates low and in 2005 they increased the policy interest
rates three times during the year.
Nevertheless
through open market operations they have succeeded in containing
inflation despite the external shocks of oil prices. Like in most
other countries our Central Bank too has resorted to precautionary
monetary tightening. However being highly import dependent achievement
and sustainability of low inflation expectations is no easy task.
A quotation
from the Governor of Reserve Bank of India as said by Dr Jadhav
is worth being emphasized. "The conduct of monetary policy
is getting increasingly sophisticated and forward looking, warranting
a continuous upgrade of monitoring scan and technical skills. Flexibility
and timeliness in policy responses coupled with transparency and
accountability hold the key to further enhance credibility. Above
all the monetary authority has to address dilemmas, which exert
conflicting pulls at every stage, and blend the desirable with the
feasible. We have to recognize that judgments are involved at different
stages which call for both knowledge and humility".
Given
the adverse effects of both inflation and deflation and the necessity
to maintain price stability considerable responsibility rests on
the monetary policy makers particularly in countries like Sri Lanka
with high income disparities to maintain price stability within
the sensitivities of political objectives of the governments in
power.
(The
writer could be contacted at suvink@eureka.lk)
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