The Sunday Times The Economic

The relationship between inflation and economic growth is complex and controversial. The controversy on the control of inflation that arose at the recent Central Bank Anniversary Lecture was only a small reference to a large and complex issue on which economists have chosen to disagree.

The presentation of data on the correlation between growth and inflation in countries is hardly adequate to settle this issue. Inflation arises due to a host of reasons and therefore economists have labelled inflation in many diverse ways: "cost-push", "demand pull", "import induced", are among some of these descriptive terms.

Milton Friedman has insisted that inflation is a monetary phenomenon and therefore its control lies in the control of the money supply. Others, particularly development economists, have placed a greater emphasis on domestic production, as inflation has been defined as" too much money chasing too few goods." Therefore it is contented that the increase in production is the cure for price increases.

Some economists have argued that a little inflation stimulates growth, others that such inflation could grow in momentum and damage the long term capacity to grow by discouraging production and encouraging speculative gains in trade and real estate and lesser competitiveness in international markets.

An underlying assumption in many discussions on inflation is that an "overheating" of the economy brings it about. When economies grow rapidly the demand for resources rises sharply and therefore the prices of those resources, including the general wage level increases. This leads to an inflationary spiral that could feed on itself and lead to higher and higher levels of inflation. The dangers of such an inflationary spiral is well recognised, though some economists are of the view that a little bit of inflation would do more good than harm to economic growth. Other economists have argued that a little bit of inflation, like a little bit of pregnancy, tends to grow. In a globalised world domestic inflation could render a country's exports uncompetitive in relation to the exports of other competing countries, if its rate of inflation exceeds those of its competitors. In such a situation the depreciation of the currency is inevitable.

This overheating of the economy is going on in China and India at the moment, as their economies are growing rapidly and competing for domestic resources. The Chinese economy being still a centralised one has means by which these competitive forces could be kept in check and wages in particular kept down to compete internationally. India is in a different situation where market forces are the dominant influence in the economy now. Therefore resort to monetary policy measures is inevitable.

So there is a plethora of views on inflation. Inflation must be discussed in relation to the particular economic context. This is what we attempt in this column today. The causes for the current inflation in Sri Lanka are not the overheating of the economy. It is due to two predominant factors. The most compelling one is the import price induced inflation. The sky rocketing oil prices are raising domestic prices not only of petroleum products, but also electricity, transport and consequently of domestically produced goods. Had the price of some imported consumer products like cars, transport equipment or wheat flour and sugar increased, there would have been an effect on prices of other commodities as well indirectly. Yet this impact would have been minimal. There would have also been some adjustments in domestic demand that would have made indirect impacts manageable. This is not the case with oil imports that have a pervasive impact on nearly all items of general consumption.

The increase in price of oil results in higher costs of essential transport of persons and goods; increases the cost of electricity, petroleum-based other imports like fertiliser and agro-chemicals. Consequently, there is a rise in the cost of living. It is also significant that these increases in costs raise the costs of production of both agricultural and industrial goods. Where the latter is concerned it could erode the country's competitive advantage.

Unfortunately nearly half of the country's electricity generation (46 per cent in 2005) is thermal. Therefore the oil price increase has increased the price of electricity significantly. This has consequently raised prices all-round and therefore increased the costs of production of most items of consumption. The country is no longer largely dependent on hydro electricity and incremental hydro power generation is around 3 percent, when increased electricity consumption is in the range of 8 to 10 per cent. While a long term solution that is less dependent on oil has to be found by the development of alternate sources of power generation, the immediate need is for conservation in the use of electricity and of petrol.

The capacity of the country to curtail consumption of oil and oil-based products has been modest as these items are largely in the essential category. Besides this the government has made little effort to reduce its own consumption of oil that is a significant proportion of imports.

The large numbers of ministers and ministries and expanded security for them are obvious ways by which the government has succeeded in increasing its own consumption. There is also bound to be an increase in consumption of petrol owing to the ongoing war in the East and North.

The other factor leading to inflation is the increased government expenditure on salaries and welfare measures. Much of this expenditure, as well as well as the expenditure on the war, are inflationary, as they do not add to an increase in goods and services.

What is clear is that Sri Lanka's inflation is not generated by heightened economic activity resulting in an increase in goods and services.

There is no overheating of the economy in the sense in which it is discussed by economists and experienced currently by the high growing countries of China and India. What may happen is the converse. The rise in inflation could dampen the production of goods, especially those for export. Therefore the control of inflation is vital for the stability and growth of the economy. The Central Bank's role in this economic context is an unenviable one and hardly likely to succeed.