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How to control rising inflation
July 09, 2008
Inflation is fast becoming an 'internationally tradable virtual commodity' over which nation states and their central banks are losing control.
According to monetarists, inflation is primarily - in Milton Friedman's extreme formulation "everywhere and always"- a monetary phenomenon. Their logic goes something like this: if money supply were constant, and the price of a particular good, service or asset (say, steel), were to rise, a fall in the demand for, and hence price of, other goods, services and assets would take place to compensate for the relative rise in demand for steel. Ceteris paribus, the rate of inflation would remain constant, because aggregate monetary demand and supply tend to equate in a market economy.
This logic however works only in a closed economy. While economies were never fully closed, goods and services are now increasingly tradable across borders. External demand and supply pulls are therefore becoming stronger. The price of tradable goods in which there is a global demand-supply imbalance could still rise despite domestic money supply remaining unchanged or even declining. The money supply adjustment would be in the non-tradable sector, which would see a decline in prices. Conversely, excess money supply is likely to inflate the price of non-tradables, especially assets like stocks and real estate, rather than the basket of tradables comprising the consumer price index.
As global trade/GDP ratios rise sharply, the price of tradable goods is increasingly determined by international, rather than domestic, demand and supply. Most of the inflation in tradable goods over the past year, in India and abroad, has been in oil, commodities and food - marked by global demand-supply imbalances. Prices of most other tradable goods are still relatively stable on account of the efficiency effects of globalisation. While the world economy taken together can be seen as closed, the role of nation-based monetary policy is becoming increasingly marginal in impacting domestic consumer price inflation.
Current inflationary expectations need to be seen against the backdrop of the remarkable price stability of the opening decade of the 21st century, combining record levels of output growth with low rates of inflation. According to IMF estimates, global output rose from an average of 3.2 per cent per annum in 1989-98 to 4.4 per cent in 1999-2008, driven by a dramatic increase from 3.8 per cent to 6.4 per cent in emerging and developing economies.
This price deflation occurred despite the Goldman Sachs broad commodity index jumping by 288 per cent over the six years to February 2008. This led to a major disconnect between consumer and commodity prices, reflected in an emerging gap between core and headline inflation.
On account of the disinflationary effect of globalisation on tradable goods and services excess money supply mostly impacted non-tradable assets such as real estate, or partially tradable financial assets like stock prices. This excess liquidity is commonly attributed to the burgeoning trade surpluses of developing countries on the one hand, and their consequential reluctance to appreciate their currencies on the other.
The recent surge in commodity prices, particularly oil and foodgrain, indicates that supply side constraints have at last caught up with record levels of output growth. Emerging markets are now exporting inflation through their unquenchable demand for commodities, even as OECD countries export "agflation" by diverting food grain for biofuels.
If the monetary policy of nation states is being increasingly emasculated by globalisation, domestic inflation can nevertheless be suppressed by insulating the country from world markets in those tradables where there is domestic oversupply, and/or by subsidising those tradables where there is domestic short supply.
Suppressing inflationary pressures cannot however neutralise the fall in the real income of the country's population consequent on the increase in the price of imports. Somebody has to bear the costs.
As for monetary policy, a restrictive stance could impact inflation on the margin by preventing higher import prices from working their way into higher wages and into general domestic prices. However, to make a meaningful dent on hyperinflation in a rapidly globalising world, developing and developed country central banks, in particular the US Fed that continues to follow a loose monetary policy, need to orchestrate their inflation targeting.
The writer is a civil servant. Views expressed here are personal.
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