Inflation back with a vengeance 

By Eric Ng Ping Cheun

Inflation in Mauritius has bottomed out. Inflation, as measured by both the year-on-year and twelve-month average methodologies, has been rising steadily since last October. Year-on-year inflation has jumped to 6.4 per cent in January 2011 while the headline twelve-month average inflation has firmed up to 3.3 per cent. The latter will soon cross its historical average level of 4 per cent.

Some prominent economists seem to downplay the resurgence of inflation on the pious pretence that the increases in prices are one-off, being induced by budgetary measures. Their reasoning is that we are witnessing a cost-push inflation (cost inflation pushing prices up) resulting from non-monetary factors (wage push and climb in prices of oil, food and raw materials), rather than a demand-pull inflation (price inflation pulling up costs). So, they argue, this does not warrant a tightening of the monetary policy.

Such arguments are specious or, at best, mix truth with error. What should worry us are not the causes of inflation, but its consequences. And the higher the rate of inflation, the more serious are the consequences for both businesses and households. An annual inflation of 5 per cent (open inflation) becomes intolerable as it brings significant changes in the income distribution, rapidly lowers the purchasing power of the local currency, depreciates securities, life insurances and mortgages, impoverish fixed income earners, discourages saving, favours capital flight, allows wrong investments and retards economic growth.

But even an average price rise of 3 per cent a year (creeping inflation), if continued several years, cannot be called negligible. It becomes a grave problem if there are no reversals of the price rise or only short spans of stable prices. The fact is that Mauritius has never experienced an annual price decline, but has lived under chronic, not intermittent, inflation as its long-run trend of the general price level is upward.

Mauritians have a strong inflation psychology

A US judge once said he could not define pornography, but knew it when he saw it. The same goes for inflation. When inflation keeps its momentum and is never stopped by price declines or at least by prolonged periods of stable prices, more and more people come to expect further price increases. Such expectations become an accelerating force for inflation as they translate into greater wage demands (employees want to secure real purchasing power) and into higher interest rates (lenders seek protection from the depreciation of the value of money while borrowers think they can afford to pay more bank interests because the prices of their products will go up).

The twelve-month average inflation has stayed below 3 per cent for only the past fourteen months: the interlude has been too brief to restore public confidence in the stability of the value of money. It is therefore an illusion to believe that a creeping inflation can remain so indefinitely. The amount of time it takes before it starts to accelerate depends on many factors, among them past history. In Mauritius, people have gone through a severe inflation experience, have thus a strong inflation psychology and so react quickly to price increases. It takes only a short period of renewed uplift in prices to rekindle fears of open inflation, which lead to anticipatory purchases turning the creep into a trot.

Schumpeter and Keynes argue that inflation promotes economic growth by creating profits which are financial sources of investment. Still, a moderate inflation can stimulate growth provided that prices keep ahead of costs to generate the necessary profit incentives for investment. If, however, a strong inflation psychology develops and becomes widespread, and if wages remain flexible upward but rigid downward, even satisfactory profits will lead to wrong investments that entail a misallocation or a waste of resources. But if the increase in wages is kept within the annual average growth in labour productivity (3.4 per cent between 1999 and 2009), then stable prices can provide the same stimulus to investment and to growth.

It is said that firms should cover an excess of wages over labour productivity by a rise in prices. Otherwise, an inflationary wage push would force them to invest in labour-saving machinery, to upgrade their production methods and to cut unnecessary expenses in order to remain in business. In fact, the inducement to restructure cannot be attributed solely to cost-push inflation, for it comes inevitably from the normal forces of competition.

Inflation is always a monetary phenomenon

The cost-push theorists are right on one point: inflation is the result of deliberate government policy. Salary earners have been accustomed to annual wage increases decided by the authorities, such that the political risks of withholding salary compensation across the board for just one year have become too high today. To avoid undermining employment, the government can only assume that workers do not realize the difference between nominal and real wages. But this is an untenable assumption because you cannot fool all the people all the time. When Keynes wrote about money illusion during the Great Depression which saw prices falling, he was thinking of wage reductions, not wage increases.

A jump in wage costs cannot translate into a rise in prices without expansion of the money supply. In the absence of monetary growth, it would merely bring about further unemployment. Inflation is always a monetary phenomenon, not a price phenomenon: prices go up because inflation is happening, not the other way around. Prolonged inflation is likely to create a wage push as it gives strength to labour unions.

There can be no inflation without an increase in aggregate demand, and there can be no sustained expansion in aggregate demand without a rise in money supply. It is noteworthy that banks’ claims on the private sector grew by 10.5 per cent in 2010, a rate which better described private credit inflation than the so-called “credit slowdown” that was hailed in some quarters. Hence, the only means to control inflation is to jack up the interest rate.

Money supply gives a better picture of inflation than the consumer price index (CPI). The former is an economic variable whereas the latter is just a statistic and is based on a mythical household budget portrayed as an average. The CPI approach supports the fallacious notion of cost-push inflation whereby the cause of rising prices is, well, rising prices.

Instead of a rise in the price level, inflation can be defined as an expansion in the monetary circulation, which includes currency outside banks and demand deposits. Here inflation, as measured by the growth of narrow money liabilities, was 4.8 per cent for the year 2010, assuming that the velocity of circulation of money was constant. Of course, changes in money supply cannot reflect exactly in prices because of time lag and anticipations. Still, inflation occurs when the value of money declines relative to the goods and services it can purchase. This happens when too much money chases too few goods.

There is no true measure of inflation in a situation where the banking system is flooding the economy with new rupees and where there exist many government operated, sponsored or induced price maintenance and price support schemes. But what is certain is that inflation remains a permanent part of our economy.

* Published in print edition on 3 March 2011