Explaining recent inflation persistence

The ongoing episode of high inflation in Bangladesh was fanned by global price increases. Its persistence is a domestic artefact, especially the disconnect with reality in the handling of the exchange rate and monetary policy. Administered price increases (fuel, gas, electricity), foreign exchange shortage, and domestic credit expansion added fuel and created conditions for several profit push to inflation. 

Persistence distinguishes the latest variant from its global counterpart. Inflation started rising from January 2021, well ahead of the Ukraine war; gained momentum in April 2022 in the immediate aftermath of the war; and subsequently got entrenched above trend.

This is very different from the behaviour of the global inflation rate. Median headline global inflation is estimated at 7.2% (year-on-year) in April 2023, down from a peak of 9.4% in July 2022 (World Bank 2023) and is forecast to average 6.8% in 2023 (IMF 2023). Global commodity prices in the first quarter of 2023 were roughly 30% lower than their historic peak in June 2022. Energy and food prices have dropped substantially from their 2022 peaks. The establishment theory that inflation is all imported is hard to reconcile with these facts. 

More revealing is the relationship between inflation itself over time. Figure-2 plots inflation in month t (y-axis) with inflation in month t-1 (x-axis). Last month's inflation is almost a perfect predictor of inflation in the current month with a slope equal to 0.996. A one percentage point increase in inflation this month predicts almost an equal increase in inflation next month. This is path dependence par excellence. What made it so?

Administered price increases and the knock on effects

Petrol and octane prices increased close to 50% and diesel and kerosene 36% in August 2022 on top of a 23% increase in November 2022. Retail electricity tariffs increased 15.7% from January to March 2023. Average price of gas increased nearly 23% for retail consumers in June 2023. These have a direct, albeit transitory, effect on headline inflation limited by the 4% weight electricity, gas, and liquid fuel have in the urban CPI basket and about 2% weight in the rural CPI basket. 

In theory, knock on effects – the secondary consequences from relative price increases such as the above – can result from cost push and demand drag. Increased energy prices increase costs in energy intensive activities which are then passed on to consumers. They also reduce real incomes of households which drags demand in general. The working of these opposing forces can explain why the secondary effects lack salience in the details of data on various components of inflation. 

One interesting fact is the relationship between food and non-food inflation. During the 24 months in FY19-21, food and nonfood inflation had a negative correlation (0.55). It has turned positive and become stronger (0.65) in the subsequent 26 months. 

The demand drag effects of food price increases can explain the negative correlation between food and non-food inflation. A faster rise in food inflation, as was the case during FY19-21, relative to aggregate prices, may have lowered demand for non-food products via the income effect on the vast majority of net buyers of food. Given a 45% food share in the CPI basket, a 10 increase in food prices implies a 4.5% decrease in real incomes on average. Reduced real income causes proportionately greater decline in consumption of non-food items compared to food (Engel's law), hence taking a few breaths away from rise of non-food prices.

The knock on effects are second order important in explaining inflation persistence. The cost push effects in the aftermath of the domestic energy price adjustments is unlikely to have been the transformer of the correlation between food and non-food inflation. There is no trend in the ratio of monthly (year-on-year) food and non-food inflation (Figure-3). The ratio peaked thrice during FY19-23 – once in October 2021 (1.47), then in May 2022 (1.36) after bottoming (0.79) in January 2023, and topped the last two tops in August 2023 (1.58). The trend is flat at 1.0 in monthly (y-o-y) data covering FY19-23, suggesting food and non-food inflation tend to converge in the long run underpinned by drivers common to both.

Exchange rate policy 

The taka-US dollar rate matters most for Bangladesh because our trade is largely denominated in US dollars. As the dollar gains strength against the taka, so does the rate of inflation (Figure-4). The correlation between the exchange rate and the headline, food and non-food inflation was 0.94, 0.82 and 0.94 respectively. 

There is more than meets the eye. It is easy to conclude that taka devaluation caused inflation to increase. However, take a look at the cluster of observations in Figure-4 when exchange rate changes were close to zero. Inflation varied from 5 to 6.5%. There are large variations around the line best fitting the scatter between inflation and the exchange rate changes. Several other variables changed as well.

Bangladesh Bank restricted import demand administratively, prioritising certain transactions; capped rates for export, remittance and import; and protracted certain current payments. The use of multiple de facto official rates, erring on the side of over-valuation, assumes a stronger than otherwise currency will support growth and contain inflation. Lobbies having privileged access to foreign exchange at the overvalued BB rate loved it. The hope was that the global commodity price increases will reverse, and geopolitical shock will not aggravate, thus justifying buffering through forex reserve adjustments. These did happen, yet inflation moved on.

The exchange rate policy hosted the persistence of inflation. Foreign exchange shortage strangulated supply in the markets for goods and services. A pre-existing parallel market for current transactions gained momentum as many moved for a better selling price or because they cannot obtain dollars at prices set by Bangladesh Association of Foreign Exchange Dealers Association and the Association of Bankers Bangladesh. Wider spread between the official and parallel rates diverted dollar inflows from formal channels.

Foreign exchange shortage – excess of demand over supply at the prevailing exchange rate – is not directly observable. Nor are the parallel rates. A comprehensive measure of the availability of foreign exchange is the stock of net foreign assets (NFA) in the banking system. It is not unreasonable to assume the stock of net foreign assets declines as shortage grows and parallel market premium rises under conditions where the formal market rate is not allowed to adjust to market clearing level. Banks drew down their nostro account balances. BB continued to sell dollars at an increasing rate. 

These circumstances imply a negative correlation between the growth of net foreign assets and headline inflation. Figure-5 shows such a relation emerged recently. The large cluster of observations of positive and often high NFA growth at around 6% inflation shows NFA growth variations in the positive territory did not matter for inflation. Inflation increased with the onset of an increasing rate of NFA decline. The administered regime shifted the inflation trajectory upwards by creating foreign exchange shortage. The parallel market rate gets baked into the inflation rate as firms and households use this rate in costing and pricing. The implication is lifting the cap on the selling and buying rates will not necessarily add to inflation.

Domestic credit expansion

Despite the lack of a stable relationship between monetary growth and inflation, the view that inflation is ultimately something that central banks determine, at least on average, over time is widely accepted. But beware of simplistic reading of recent data which shows a negative (0.75) correlation between broad money growth and inflation!

The devil is in the details. Broad money comprises net foreign and domestic assets. The decline in NFA soaked taka liquidity from the banking system as BB sold dollars. A large pre-existing stock of excess liquidity buffered the impact on banks' capacity to lend. The monetary effect on inflation came from the net domestic assets component, of which domestic credit is the dominant part. Given a 9% lending rate cap since April 2020, credit remained cheap. Still so. Following the easing of the pandemic from the second half of 2021, pent up demand unravelled not just in the market for goods and services but also for credit. 

Growth in domestic credit fed inflation (Figure-6). The correlation coefficient is 0.7. Just like exchange rate changes and NFA growth, there is a large cluster of observations where inflation appears unrelated to domestic credit growth. These pertain to FY21 when the economic growth was recovering from the pandemic sudden stop.

Profit push inflation

There is a general perception that firms or informally connected groups (syndicates) abuse their market power to increase prices, contributing to inflation (price gouging, greedflation). High inflation after the pandemic came with high corporate profits and falling real wages in many countries. There is strong evidence of falling real wages and anecdotal evidence on rising corporate profits in Bangladesh. This has naturally raised eyebrows on the role changes in profit margins play in driving inflation. 

Many central banks are beginning to pay attention to the relationship between changes in profit and inflation. Profit push inflation can accelerate existing inflationary pressures. Rising oil prices, for example, lead to increased costs for firms who then find it opportune for increasing profit margins. Companies with access to the official exchange rate make excess profits by setting prices in accordance with the expectation of a significant depreciation in the near future. 

Economic theory is ambiguous on the dynamics of profit push inflation. Firms facing limited competition can raise markup over input costs taking cover under higher inflation. Alternatively, strong domestic demand can cause increased profit margins as prices rise to match demand to supply limited by controls on imports and use of foreign exchange. Maintaining profit margins is not profit push. Changes in firms' pricing power or market gouging are.

Profit push inflation needs a trigger such as tighter global (food, energy, metals) market conditions, exchange rate depreciation, foreign exchange rationing, accommodative or expansionary monetary policy and so on. Admittedly, lack of hard evidence on a broad-based increase in domestic profit margins, beyond several essential mass consumed food items, make it difficult to be empirically certain on the significance of rising mark ups as an independent cause of inflation persistence. But its prominence in the popular inflation narrative is undeniable, reinforced by the authority's confirmation of price gouging. 

Narratives are known to drive events, but also vice versa. This phenomenon shapes perceptions of how fairly the nation's income is shared between workers' income, corporate profits, and, for that matter, the government.

Macro problems require macro solutions

Inflation is often used to describe a rise in some prices. We have edible oil, rice, chilli, sugar, onion, pharmaceuticals and, both literally and also figuratively, chicken and egg inflation. When the prices of some goods increase, markets respond by supplying more of those goods. When the prices of virtually all goods increase, there is little any one can immediately do to supply more. 

Such inflation was propagated and nurtured by foreign exchange shortages made worse by controls, domestic credit growth, and profit push under tighter supply constraints. Pervasive and persistent inflation requires some form of domestic demand, not micro-management while easing specific supply bottlenecks.

Zahid Hussein is a former lead economist of the World Bank, Dhaka Office