Inflation and Fiscal Policy

I was going to write about this issue yesterday but didn’t have time. Now William Pesek makes the same point (excerpt):

Inflation Above 9% Shows Bankers No Longer Gods
William Pesek

March 1 (Bloomberg) -- Duvvuri Subbarao knows a thing or two about inflation. India’s central-bank head defeated price gains exceeding 10 percent twice in the past two years alone.

Now, Subbarao is back at battle stations as a chorus of traders say he’s behind the curve. It’s hard to argue with the wisdom of markets with Indian inflation back above 9 percent, the highest among Asia’s 10-biggest economies.

Yet the Reserve Bank of India is the vanguard of a worrisome phenomenon in the world’s most vibrant economic region. Central banks are in over their heads and need help from politicians. Higher interest rates alone won’t cut it.

Subbarao personifies the shifting economic sands. Prior to taking the monetary reins in September 2008, he was a top World Bank economist from 1999 to 2004. Back then, central bankers like then-Federal Reserve Chairman Alan Greenspan were treated like gods for their supposed omnipotence to tame inflation.

Several asset bubbles and one global crisis later, we know better. The ongoing surges in prices of commodities such as food are fanning Asian inflation and they require bold action. Higher rates will only do so much. It’s time for politicians to do their part to reduce fiscal-stimulus excesses.

There’s two basic causes to inflation, labelled appropriately “cost-push” and “demand-pull”. The former is a supply-side phenomena, where restrictions or disruptions in supply of goods or services relative to demand cause prices to rise. The current turmoil in the Libya, which has effectively halted around 2% of the world’s oil production, is a good example of this phenomena. For food, the critical factor is the weather, which has been hot and dry interspersed with excessive rainfall causing floods over the last couple of years, thus reducing global harvests. Cost push is generally cyclical (think weather patterns), and shouldn’t persist.

But of the two, demand-pull is the more dangerous because its directly related to inflationary expectations. Demand-pull occurs when there’s consistently higher demand for goods and services relative to supply. The dangerous part of it is when higher demand-led inflation then induces corresponding wage demands by workers because they expect inflation to continue at the higher level, which causes prices to rise further and which then causes workers to demand more, and so on ad nauseum. This is the dreaded inflationary spiral, where inflation begets higher inflation, which causes prices to rise further still.

Now in this narrative view, you can see the social welfare conundrum – the only way to stop an inflationary spiral from beginning is to effectively accommodate the loss in household purchasing power. In central bank code, this is called “anchoring inflation expectations”. The impact will be greatest on those with the highest propensity to consume i.e. the poor and the lower income groups.

Most of the time, it’s the responsibility of the central bank to maintain price stability (generally defined as inflation less than 2%) through the use of monetary policy. Raising interest rates (“tightening policy”) reduces the relative demand for credit in an economy which then reduces aggregate demand – you reduce inflationary pressure in a demand-led inflationary environment by indirectly reducing demand i.e. income. Obviously the impact will be different depending on the sensitivity of different industries and household budgets to interest rates – monetary policy is a blunt instrument, not a surgical one.

Another less obvious way to reduce demand is to do it directly via government fiat – in other words, an incomes policy where worker compensation is directly restricted through union bargaining. Again, workers have to bear the brunt of the reduction in purchasing power.

And lastly, you can also cut aggregate demand by restricting the one thing the government has direct control over – its own expenditure. The point that Pesek (and others) is making is appropriate: with India’s economy running at or above its potential output and with hot money still attracted to the higher yields offered by emerging market currencies, monetary policy is not the best or only tool for the job.

We’ll have to differentiate here between long term public investment (which raises current demand but also future output and supply), and operating expenditure (which just raises current demand). But this is a policy option that many emerging market governments appear to be avoiding.

Is Malaysia in this situation? Not yet – while inflation is accelerating, it’s still below trend and we haven’t fully closed the gap between current output and potential output. More to the point, BNM was ahead of the rest in raising interest rates post-crisis, and there’s evidence that the government is also doing its part in restricting expenditure, deficits notwithstanding.

But this is a lesson to remember – when it comes to fighting inflation, there’s more than one way to skin a cat.