ISSN: 1391 - 0531
Sunday June 08, 2008
Vol. 42 - No 54
Columns - The Sunday Times Economic Analysis  

Rising inflation threatening economic stability and growth

By the Economist

The fuel price increases and increases in transport costs have already demonstrated the truth of our last week’s statement that there is no light at the end of the tunnel where price increases are concerned. We may in fact be at the threshold of further increases in prices. The hike in oil prices has come to such a level that the government is at last jolted to think of measures to curb, if not control, fuel consumption. We hope the severity of the problem will also ensure measures of fiscal discipline. As we have often argued in these columns there are some measures that the government can take to tame inflationary measures and these should be taken immediately.

Inflation is a worldwide phenomenon today. Nearly every country in the world is experiencing a rise in prices. In some countries it is causing protests and social tensions. However the rate of inflation varies considerably. Sri Lanka is among the high ranking countries on inflation at around 30 percent in the company of countries like Venezuela and Argentina. The two large countries of Asia that are experiencing high growth have also experienced higher rates of inflation in the last twelve months. India’s rate of inflation was last estimated to be 7.8 percent, much higher than what was thought to be a tolerable level politically. In fact this may be the reason for the recent defeats of the Congress Party in state elections. What is worse is that the rate of inflation is expected to rise in the next few months and may come close to double digit levels. China too is experiencing a much higher rate of inflation than in the past. The natural misfortune of the earthquake recently may aggravate the situation. China’s official estimation of the rate of inflation is 8.5 percent. It is generally believed by economists to be an underestimation of the real rate of price increases. This is due to the index not covering a number of consumer items and being heavily weighted towards controlled prices.

In fact in the current scenario of world inflation many estimates of inflation are suspect and are considered underestimates of the actual rises in prices. This may apply to the Sri Lankan case as well, especially as there have been attempts to exclude certain items of consumption from the index. There are also efforts to explain away inflation as a phenomenon that is not the responsibility of governments but the inevitable result of the increases in the international prices of oil and of food. As we pointed out last week this has more than a kernel of truth, but in the case of high inflation countries like Sri Lanka, there were inflationary pressures built up over time and remedial actions were inadequate. It has also to be recognised that in the face of inflation induced by import price increases the capacity of governments to control inflation tends to be restricted. Traditional monetary policy measures may be quite inadequate. Besides, economists believe that their use may in fact harm the economy and throttle growth and consequently be a cause of inflation in the long run. Especially in the United States, the problem is compounded by the fact that demand has declined and there is a need to stimulate what Keynes called “effective demand”.

The causes for the current world inflation are many. The sharp rises in oil prices have raised the costs of production and of transport in most countries. Even in an oil producing country like Indonesia owing to disruptions in production oil prices are to be increased and this is politically dangerous. The rise in oil prices has resulted in the costs of production of many items rising and consequently raising the general price level. The most insidious impact has been on agricultural production, where the rise in costs of petroleum based inputs like fertiliser, insecticides and fuel costs have resulted in the increase in prices of many important food grains. This coupled with possibilities of using land for bio fuels rather than food production has apparently led to a reduction in food output. However there is some controversy as the extent of such alternate uses may not be of an extent that resulted in a reduction in food production that led to the rise in food prices. What appears to have been more important is that over a long run, food prices have not kept pace with other price increases and thereby made food production less attractive. Coupled with this factor were the adverse weather conditions around the world that reduced grain production in particular.

While much of the focus of attention has been on the reduction in supply, commentators have pointed out that the price increases have been mostly due to increases in world demand for food. The economic growth of the highly populated countries of Asia has been responsible for a surge in demand for food. The increasing populations of these countries that are annually large and the improvements in their per capita incomes, have resulted in a huge increase in demand for food. The rising per capita incomes have also meant that the tastes and preferences for food have changed from grains to meat, poultry and meat products especially in China. Meeting this increased demand for meats means that many more amounts of grain have to be used for the production of meat. Therefore this demand has been of a higher magnitude than the direct demand for grains. In this context the supply elasticity for food has been inadequate to cope with the demand resulting in higher prices of wheat, rice and other grains. Supply factors as well as demand have been responsible for the surge in food prices that has resulted in the coining of the term agflation.

What is important to realise is that many of the factors responsible for the increases in food prices are not temporary. Similarly the prospect of oil prices declining is also weak both due to the continuing increases in demand especially from China and emerging countries and the diminishing stock of oil the world over. With these underlying factors that are not temporary, it is imperative that the government undertakes measures of fiscal discipline and pursues economic policies that look to the stability of the economy in the long-run rather than short term political gains. The current uncontrolled inflation could ruin the economy and negate the gains of the economy of the past. Controlling inflation is not merely an issue in prices but one of concern to the productive capacity of the economy.

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