A high rate of inflation is a serious concern for a country’s development. This is especially so for an import export economy like Sri Lanka. A rate of inflation higher than that of competing export countries leads to higher costs of production that weaken the country’s export competitiveness. Reduced export earnings imply loss of employment and lower incomes to workers in industries affected by lower exports. Restoring the country’s international competitiveness then requires a depreciation of the currency that increases import costs and creates fresh inflationary pressures.
Domestic inflation makes import commodities relatively cheaper in relation to domestically produced goods and consequently increases imports and strains the balance of payments. Furthermore, increases in the cost of living cause severe hardships, especially to the lower end of wage earners and fixed income earners.
This in turn could lead to demands for higher wages and industrial unrest. Inflation also distorts investment decisions by making speculative and trading activities more remunerative than investment in production.
For these reasons, inflation is considered a serious destabilising factor in an economy. Measures to control inflation have a high priority in modern economic policy management. The Sri Lankan economy has faced severe economic difficulties in the past owing to high rates of inflation. The reasons for high rates of inflation in the Sri Lankan economy have been the large fiscal deficits, huge war expenditure and high prices of imports.
Rising rates of inflation
One of the achievements of the Sri Lankan economy in 2010 was that it was able to keep the rate of inflation at a single digit level. This is not a mean achievement for a country that is on a path of economic recovery, high investments in infrastructure, large inflows of capital and the economy’s vulnerability to the vicissitudes of international price movements.
There are noticeable signs of inflation this year. In January 2011, year-on-year inflation was 6.8 per cent. This increased to 7.8 per cent in February. In its comment on the price rise in January the Central Bank said the increase in the index was largely driven by the food and non-alcoholic beverages. The increase in food prices during the month was attributed to the adverse weather conditions that also affected the higher increase in February.
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The Central Bank is hopeful of prices subsidising in the coming months. It said, “While the paddy output is expected to be affected due to recent floods, the availability of stocked-up paddy and the possibility of the increase in the extent of cultivation during the yala season are likely to ease any price pressures in 2011. The recent price surges in other food crops are expected to subside as the situation normalises in the coming months.” The Central Bank is confident that the rate of inflation could be contained within single digit proportions this year too.
There are however reasons to think that inflationary pressures would be high during the rest of the year. The increase in domestic food prices may continue for much longer than the government and Central Bank expects. This is so as international food prices too are increasing and import prices may stimulate inflation.
The government has been slashing duties on food imports but there is a limit to this strategy if international prices increase sharply. The international prices of oil is being destabilised by the unrest in the Middle East and there is every prospect that oil prices would rise. If these price increases are passed on to consumers by way of increased petrol and diesel prices, it would fuel price increases of many commodities that are affected by increases in transport costs.
Scepticism with statistics
The statistics of the inflation rate is received with scepticism by the general public. There are many reasons for this. Sharp increase in food prices recently is a primary reason for this popular scepticism. There is also a suspicion that the calculation of the index does not use actual market prices that most consumers pay. They are probably collected from a few selected places that are not representative of market prices. There are also some doubts as to whether certain commodities are dropped from the index when their prices rise on the spurious grounds that these are not bought by people. Recent attempts to revise the basket of commodities have added credibility to this view.
The public perception of prices is partly due to a lack of understanding of price indices. The deceleration in inflation is not believed as it is often misunderstood as a decline in prices. This is certainly not the case. When the rate of increase declines, prices are still continuing to increase, though at a lower rate. When people experience further increases in prices, they tend to disbelieve that the rate of inflation has declined, as prices of commodities have not decreased. For instance, if the annual rate of inflation were to be 6 per cent this year, what this means is that average prices rose by 6 per cent. This is an increase on top of last year’s increase in prices.
Furthermore, the increase in the consumer price index is an average of all consumer prices, where some prices such as those of rent would not have increased, while food prices may have increased by 20 per cent. The perception of the general public is based on those prices that affect them mostly. Since food prices have risen sharply in recent months the perception is that price increases are much higher than what the index discloses.
Increasing price trend and interest rates
Besides these misconceptions on what inflation means and its measurement, there is a current debate as to whether we are at the end of the declining trend and whether the rate of inflation would rise this year. This discussion has a direct relevance to the issue of whether the monetary policies in place could cope with a possible resurgence in inflation. The Central Bank and the IMF appear to view the higher inflationary trend as not one for anxiety and that a reversal in monetary policy is inappropriate. Therefore the Central Bank has decided that the current monetary policy stance is appropriate and that policy interest rates of the Central Bank will be maintained at their current levels of 7 per cent for Repurchase and 8.5 per cent as the Reverse Repurchase rate. The Central Bank has signalled that commercial banks need not raise their rates.
As is usual in discussions on inflation, there are varied views on the control of inflation. If the trend of price increases continues and gains momentum, then the current policy would have to be revised and interest rates increased. Will such a move be too late? This is the controversial question. Milton Friedman has pointed out repeatedly that inflation is, and is always, a monetary phenomenon, and unless monetary measures support the rise in prices it cannot go on. Therefore timely changes in monetary policies are critical for containing inflation.
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