Inflation is simply the continuous increase in the prices of common consumer commodities over a sufficiently long period of time. To measure these price increases, countries compile consumer price indices regularly by using the market prices of consumer items which an ordinary consumer normally consumes. In Sri Lanka, this is being done by the Department of Census and Statistics by compiling a new price index covering the prices of consumer items in the city of Colombo and the index is called the New Colombo Consumers Price Index or NCCPI. The percentage increase in the index value over the value that prevailed 12 months ago is normally taken as the current inflation rate, though, by definition, inflation is a long term price development.

To prevent the personal preferences or prejudices of index compilers from creeping into the selection of consumer items, the choice of the consumer items is made after conducting comprehensive consumer surveys periodically. This is important because the index measures the prices faced by a typical consumer and not the prices of commodities which the compilers want them to consume or refrain from consuming for whatever the reason.

Inflation Makes People Poorer

All individuals are concerned about inflation because it makes them poorer unless their incomes increase faster than inflation. For instance, if the annual inflation rate is 5% and an individual’s income increases only by 2%, then, he becomes poorer by 3% at the end of the year. Hence, what matters to people is not the inflation rate per se, but whether that rate is higher or lower than the increase in their incomes. Since everyone aspires to become richer over time, inflation rates higher than the increases in incomes are a matter for worrying and concern.

The Poor are the Worst Hit by Inflation

Rich people are in a position to avoid becoming poorer due to inflation by getting their incomes to rise faster than inflation. Anyone visiting a medical specialist or a lawyer will experience that the fees they charge have risen faster than inflation thereby placing them in an advantageous position. This is not the case with the poor people because they do not have ways of raising their income at their own will. Hence, it is the poor people who get hit mostly by inflation.

Governments too Lose from Inflation

A government should be concerned about inflation for two reasons. First, inflation directly jeopardises government’s chance of returning to power, since dissatisfied voters could overthrow it at elections. Second, inflation thwarts the government’s objective of attaining continuous long term economic growth, because it hinders people’s ability and willingness to save, invest and commence businesses that bring them long term returns. Hence, it is always in the interest of the governments to keep inflation at low levels, if they want to remain in power.

This is why governments have mandated independent central banks or monetary authorities to take suitable measures to prevent the inflation from raising its ugly head. In Sri Lanka, this mandate requires the Central Bank to pursue, as a core objective, ‘the attainment of economic and price stability’.

Why Economic and Price Stability?

The term economic and price stability is puzzling, but it requires the Central Bank of Sri Lanka to target a goal beyond maintaining a merely stable level in a price index. It in essence calls upon the Central Bank to maintain stability in the three major markets in the economy: the market for goods and services, the market for money and the market for foreign exchange. Al these three markets are interconnected and if there is any instability in one market, it will affect the other two markets driving them too to instability.

These three markets are governed by three different prices, the goods and services market by the general price level, money market by interest rate and the foreign exchange market by the exchange rate. A central bank cannot stabilise all these prices simultaneously. It could do so only with respect to one price. Hence, if it tries to stabilise the exchange rate, it has to forgo the stabilisation of the other two prices. Similarly, if it tries to stabilise the interest rate, it has to forgo the stabilisation of both the general price level and the exchange rate.

This means, of necessity, its attempt at stabilising the general price level requires it to allow the other two markets to become stable by changing their respective prices up or down appropriately on the basis of whether there is a deficit or a surplus in the market. If these two markets are unstable, that is, if there are deficits or surpluses in them causing interest rates or exchange rate to rise or fall, then, the Central Bank of Sri Lanka is deemed to have failed to fulfil its statutory mandate. Hence, any artificial fixing of either the interest rate or the exchange rate will reduce, to a mere temporary achievement, the Central Bank’s gain over price stability by having a slow increase in a price index.

The mandate of economic and price stability requires the Central Bank to attain a situation where there are no deficits or surpluses in all the three markets and, therefore, no pressure for the respective prices to change upward or downward.

Should the Country be Complacent about Falling Inflation Rate?

In the current context, the much talked about low inflation in Sri Lanka appears to be a development about which the country cannot be complacent.

In the first place, there is a statistical cause for the index to record a slow growth in the current period. This is because 12 months ago, Sri Lanka had the highest inflation rate in the history and the value on NCCPI had risen to a very high level. Compared to that high level, the current value of NCCPI has recorded only a growth of less than 2 %. But, every month, the index value rises by closer to 1 % and, therefore, by this time next year, the index should rise by about 10 – 12 %. So, as the past experience has shown, the slow growth in NCCPI will not become sustainable unless the Central Bank tightens, rather than loosening its monetary policy.

Second, NCCPI has omitted an important segment of the consumers’ basket, namely, alcohol and tobacco, presumably on the ground that the government does not encourage its consumption. Yet, its prices affect the consumers’ cost of living and all decisions relating to saving, investment and enterprise are taken by taking those prices too into account. This type of omissions create a divergence between what the people expect as inflation in the future and what the index presently depicts as inflation.

Expectations

If the expectations are higher, people will incorporate these higher expectations into wage bargaining they make with the employers. The current demand for wage increases ranging from 20% to 75% indicates that the people have formed higher expectations about the future inflation. Similarly, savers too will demand for higher interest incomes, when they place their savings in bank deposits and contractors will ask for higher prices for goods they promise to deliver in the future.

Third, the low growth of exports and the presence of a deficit in the current transactions in the balance of payments which has to be filled by short term borrowings indicate that the foreign exchange market is not in stability. The country’s past high inflation has made its exports uncompetitive and the maintenance of a fixed exchange rate during that period has worsened the situation in the foreign exchange market. At present, the oversupply of foreign exchange in the market due to short term borrowings has prevented the exchange rate from falling. But, it creates a situation known as the ‘Dutch Disease’ where short term foreign exchange receipts causing the exchange rate to become stronger will displace the country’s traditional exports. This is already evident by the cry of exporters for export subsidies and currency depreciation.

Fourth, the artificial fixing of the lending rates of the state banks by the government has destabilised the money market. The low lending rates will encourage the borrowings raising money supply and creating an artificial demand for goods and services. It will influence the general price level to increase in the future. On the other side of the coin, the reduction in the deposit rates will cause the savings to dry up and make it difficult for the economy to generate the required volume of savings for investments. It will also upset the government’s borrowing plans from the private sector which does not have savings. Hence, for the country to maintain the required economic growth rate, the country will have to finance the investments by issuing new money, thus adding another cause for the inflation to raise its ugly head in the years to come.

Hence, the current low increase in the NCCPI is not a matter for complacence at all.

The writer is a retired deputy governor of the Central Bank of Sri Lanka. To read previous columns in the series go to the WatchTower section on the main navigation panel or click on the links below.