Inflation

Identifying causes of high inflation Pakistan experienced high economic growth over six per cent during 2004-06. However, prices also started increasing at a rapid pace and the headline inflation remained above eight per cent during the last two years. The average Consumer Price Index (CPI) inflation was 9.3 per cent in 2004-2005 and around eight per cent in 2005-06.

Is there any need to worry about inflation? When is inflation bad for the economy? A reasonable rate of inflation--around 3- 6 per cent-- is often viewed to have positive effects on the national economy as it encourages investment and production and allows growth in wages.

When inflation crosses reasonable limits, it has negative effects. It reduces the value of money, resulting in uncertainty of the value of gains and losses of borrowers, lenders, and buyers and sellers. The increasing uncertainty discourages saving and investment.

Not only can high inflation erode the gains from growth, it also makes the poor worse off and widens the gap between the rich and the poor. If much of the inflation comes from increase in food prices, it hurts poor more since over half of family budget of the low wage earners goes for food. Second, it redistributes income from fixed income earners (for instance pensioners) to owners of assets and earners of large and variable income, such as profits.

In case of Pakistan, annual inflation was above 11 per cent in the 11 of the past 32 years. Not surprisingly, average real per capita income growth was 2.8 per cent in years having less than 11 per cent inflation as compared to the years of high inflation with an average of 1.5 per cent.

For Pakistanââ'¬â"¢s economy, inflation can be bad if it crosses the threshold of six per cent, and can be extremely harmful if it crosses the double digit level.

Several supply and demand factors could be responsible for this surge in inflation. Supply-side shocks can cause large fluctuations in food and oil prices, effects of which on overall inflation, at times,can be so excessive that these cannot be countered through demand management, including monetary policy.

First, increased domestic demand created an output gap, putting upward pressure on prices. Growth in private consumption on the average remained over 10 per cent between FY04 and FY06, depicting signs of demand side pressures on price level.

The relationship between growth and inflation depends on the state of the economy. High growth, without an increase in inflation, is possible if the productive capacity or potential output of the economy is growing enough to keep pace with demand. This is also possible if the actual output is below the potential output and there is sufficient spare capacity available to cope up with the demand pressures.

When the actual output catches up with the potential output, there remains no spare capacity and the economy is working at full employment level, any further gain in growth comes at the cost of rising inflation. If demand continues to grow at this stage, and the productive capacity does not expand, there is a serious threat of rapid inflation in the long run without any additional growth in the output. A prolonged phase of rising inflation in such a case can have severe consequences for the economy.

Second, the growing gap between domestic demand and production was filled by a sharp increase in net imports, which grew by above 40 per cent in FY05 and by 24 per cent in FY06. As compared to imports, exports increased by only around 10 per cent in FY05 and by 13 per cent in FY06. This resulted in a record trade deficit.

Rising trade deficit can be a cause of expectations of high inflation in future.

The expectations effect is very important since there is a danger that the current high rate of inflation can get locked into expectations of inflation.

People expect higher salaries to compensate for expected increase in prices, speculation in asset prices increases, credit meant for manufacturing sector diverts to real estate and stock markets, and hoarders, profit and rent seekers become active in expectation of high price in the future. All this can have devastating effect for the prices.

Third, fiscal policy has remained expansionary in the last few years. Expansionary fiscal policy fuels domestic demand and puts pressure on the current account deficit. It widens the investment-saving gap, which has to be financed externally. Financing of fiscal deficit through money creation adds to inflationary pressures. Increased government borrowing from central bank can have serious consequences for general price level.

Fourth, the expansionary monetary policy- high growth in money supply and loose credit policy- was believed to be contributing to high inflation. Although expansion of credit is usual in expanding economies, excessive credit growth can have adverse effects on real variables.

Rising import prices are also considered an important factor for inflation. Exchange rate, if depreciating can also put upward pressure on price level. Increase in prices of goods, such as petrol, raw material etc makes our imports costlier, impacting on cost of production.

Similarly, indirect taxes are also blamed as the main cause of inflation. The indirect taxes, such as sales tax and excise duties raise the prices of consumer goods. This creates inflationary pressure. On the other hand, direct taxes reduce the take-home income and have anti-inflationary effect. A substantial increase in support price of wheat is estimated to have an inflationary effect on consumer prices, particularly food prices. This effect is due to the fact that wheat and wheat-related products account for 5.1 per cent of the CPI basket.

The question arises as to what were the factors that stimulated the recent inflation in Pakistan?

During the first four years of the new millennium inflation remained under five per cent and then suddenly increased to 9.3 per cent in 2004-05 and settled to eight per cent in 2005-06. The growth in wheat prices and exchange rate was low in some years and high in others. However, it seems that excessive money flows towards public and private sector, along with the import price hike in 2003-04 and 2005-06 and wheat price rise in 2003-04 and 2004-05 created inflationary pressure at an alarming level. Taxes as a percentage of manufacturing sector value-added did not show any rise.

Conclusion: The attached table presents the contributions of different factors in inflation. During the 1970s, the period of great structural changes and uncertainty, the role of inflation expectations was quite evident. People consider expected inflation while making their optimisation decisions.

The 1980s were a decade of relatively low average inflation (7.2 per cent). Private sector borrowing, exchange rate depreciation and adaptive expectations were the main factors behind this growth in consumer prices. De-nationalisation enlarged the private sector and, as a consequence, private sector borrowing increased during this period.

In 1990s, the mainstream liberalisation policies picked up momentum. Frequent changes in the government, inconsistent policies, nuclear explosion and other dramatic political and economic developments put upward pressure on prices. Average inflation rate increased to 9.6 per cent. Increase in wheat procurement prices, government and private sector borrowings, exchange rate depreciation and adaptive expectations were the main factors behind the surge in inflation rate.

During 2001-04, inflation was very low. Interestingly, support price of wheat was not raised during 2001-03. CPI shot up again in 2004-05 when inflation reached 9.3 per cent. It dropped slightly to eight per cent in 2005-06. Inflation expectations alone explain 45.73 per cent of the inflation in 2005-06 and 31.1 per cent in 2004-05. This critical role of inflation expectations can be explained by emergence of the phenomena like hoarding, assets price hikes, and surge in house rents.

Non-government sector borrowing was the second most important factor. During 2004 and 2005 the growth in non-government sector borrowing has been above 30 per cent, while it was 23 per cent in 2006. This growth is reflected in the contribution of NGSB in inflation, which is 38 per cent in 2004-05 and 35 per cent in 2005-06.

Third important factor is import prices, which explains 26.7 per cent of the inflation in 2005-06 and 13.6 per cent in 2004-05.

In 2004-05, two other important factors for inflation were government sector borrowing and support/procurement price of wheat, contributing 17.6 per cent and 11.8 per cent respectively. The government taxes did not cause any significant rise in prices in 2004-05 and 2005-05. This seems logical since there has been no change in the tax to GDP ratio over the last few years.

There was no further strong pressure on import costs because of a stable exchange rate. This policy cannot be sustained for long. Trade deficits are setting the direction.

The expansionary monetary policy did contribute in promising GDP growth but it also led to the rise in consumer prices. The phenomenal growth in the flow of ââ'¬Ëœloose creditââ'¬â"¢ to the private sector played a significant role in disturbing the price mechanism. Availability of money at virtually no cost encouraged speculators and hoarders. http://www.dawn.com/2007/01/15/ebr8.htm

Overspending brings more money into people's pocket and thus raises aggregate demand in the economy, especially in the short run where production units can not easily adjusted to increase their production! This creates excess demand or demand pull type of inflation underwhich too much money is chasing too few goods and services.

In another scenario, government overspending leaves many government workers with little to no accountability. Low accountability eventually leads to a lack of motivation and production. With low production and too much money in people's pockets, we expect excess demand and demand pull inflation too!!

By Balozi Morwa

(Tanzania Investment Bank, 2013)