Financial Times

Whilst inflation is again a spectrum amid jitters in the markets, policymakers must decide whether globalization has made the future path of price rises harder to calculate.

The threat of inflation once more hangs heavy over the global economy. Anxiety about rising prices may be cloaked in decorous central banks of the world. But there is no mistaking as the swelling chorus of concern from monetary policymakers, financial makets and many of the world’s most respected international financial institutions is a concern of many. Sri Lanka’s inflation in the month of June was a staggering 17.6% but it dropped to 12% in July.

Signs of concern are everywhere. When Ben Bernanke, the federal Reserve chairman, warned recently that sharp recent rises in consumer prices been “unwelcome developments”, the financial markets tumbled, fearing further US interest rate increases. The European Central Bank has lost patience with inflation that has remained persistently higher than its 2 per cent definition of price stability. It is almost certain to raise the cost of borrowing one of these days, perhaps by 0.5 percentage points. Even the Bank of Japan – so long the land of falling prices – now worries more the “economy falling into a deflationary spiral.”

No one expects a sudden return to the bad old days of the 1970’s. Inflation as a global phenomenon was gradually squeezed from advanced economies in the decade from 1985. This “great disinflation” is expected to endure. But the concern is that the world’s pivotal central banks may have to work harder than they have done for years to ensure continued price stability.

This holds ground in Sri Lanka too. We need to rev up our exports to Rs 725 billion. In 2005 we did Rs 638 billion at 10.2% growth. On the going rate we will end the year at Rs 700 billion. The reason for this thrust should be because most of our 90,000 migrant workers are returning from Lebanon which will have a dent in the $2.5 billion we earn annually by way of foreign income through our labour force. We also have to spruce up the tourism sector. It is paramount that we have a tourism act in place so that a governing body is on place which is based on modern policies and the realities in the market place.

In the past six months underlying inflation has been on the rise across the world. Since the increase in inflation has broadly manifested itself in goods and services without direct links to energy prices, five new concerns are emerging:

Rapid economic growth
First, the rapid economic growth over the past four years has eliminated spare capacity in the US and Japan, reducing the scope for expansion to continue a pace, without boosting inflation.

Serious risk
There is a risk that high and, more important, rising energy prices will be a permanent feature in the global economy in a world characterized by surging energy demand and relatively fixed supply. The current Middle Eastern crisis is not expected to alter the long term supply situation but it remains to be seen. Sri Lanka on the other hand must pursue Ethanol based petroleum products which drive the prices of petrol down. Ethanol based-petrol can go up to a maximum of 10% of the mixing, hence reducing prices significantly.

Forces of Deflation Forces of deflation emanating from China as a result of the low prices of goods it exports to other countries might be a warning, as its endless appetite for oil to sustain industrial expansion continues to drive energy prices higher.

Calculating that the direct impact of cheap imports from Asia was to lower inflation by 0.1 percentage points a year in the US and 0.3 percentage points in Europe over the past five years Jean-Philippe Cotis, Chief Economist of Organization for Economic Cooperation and Development, argues that “experience over the past three years suggests commodity prices pressure may significantly outweigh the disinflation influence of low cost manufacturing imports.”

Hence, Sri Lanka which earns around Rs 290 billion in garments’ exports must aim for niche markets that will not alter the purchasing behaviour due to the inflationary price increase.

Monitory Indicators
Monetary indicators, including personal borrowing, have been growing red-hot in recent years, indicating there has been too much money sloshing around in the system even if the visible effects have been largely limited to surging assets markets, particularly property prices. We see this phenomenon in Sri Lanka too where the construction industry is booming. Industry specialists predict that by 2010 there will be a glut in the apartments industry in Sri Lanka.

Public expectation
Public expectations of future inflation are rising increasing the likelihood that today’s inflation will lead tomorrow’s wage demand. This will have a tight rope situation in Sri Lanka for the blue collar workers especially for union action at the time of collective agreements.

Against a backdrop of all these forces that may propel inflation upwards, global Central Bankers rightly remind the public that higher interest rates cannot reduce inflation today but that they will lose sight of future price stability. Their forecasts, they add, show demand is likely to moderate and inflation will remain under control a year and more into the future. Private sectors forecasters agree.

Temporary phenomenon
Normally the solution would be easy. Trust the model. It incorporates the latest figures and gives the best indication of whether rising inflation is a temporary phenomenon. But there is a new problem with this approach; it has been rendered less relevant by the drastic globalization of the world economy. The SAFTA agreement that will come into force soon in our part of the world is a best case in point.

Forecasting models tend to suggest inflation will rise if demand is likely to exceed potential supply in the economy and visa versa. But the links between estimates of output gaps and recorded inflation have become fainter as the world’s economies have become more integrated.