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)

Back to Top  Back to Business  

Copyright © 2001 Wijeya Newspapers Ltd. All rights reserved.