Thinking out of the box to tame inflation

The most recent edition of The Economist warns that the rich world should not take low inflation for granted even though the link between money supply and inflation appears to be broken particularly since the Global Financial Crisis. The pandemic has shown "the value of preparing for rare but devastating events" and "the return of inflation should not be an exception."

Inflation is endemic

Inflation never really left Bangladesh.  In the past five years it has most often been above 5.5%, higher than the slightly less than 5% average in developing market economies, including South Asia, during the same period. High inflation distorts decisions private agents make about investment, saving and production. There is also evidence that inflation hurts the poor relatively more. Given this strong socio-political influence of inflation, it is understandable why inflation tends to worry governments more than any other economic issues. 

Following the pandemic, prices of such items as medical supplies increased globally, and commodity prices lifted from their April trough, but the effects of weak aggregate demand outweighed the impact of supply interruptions. Consequently, inflation in advanced economies remained below pre-pandemic levels. It declined sharply in emerging markets and developing economies as well in the initial stages of the pandemic, picking up later in some countries.

Bangladesh appears to have been an exception.  Inflation (year-on-year) rose persistently from 5.5% in February to 6.4% in October before declining to 5.5% in November.  This was driven entirely by the rise in food inflation from nearly 5% in February to 7.3% in October followed by a decline to 5.7% in November.  Food inflation in Bangladesh is driven by rice prices. Rice has 24% weight in the rural and 13.3% weight in the urban CPI baskets. The correlation, based on monthly data comprising 68 observations, between the food inflation rate and changes in rice prices in rural areas is 0.93 and 0.65 in urban areas. Both coefficients are statistically highly significant.

Causes of inflation

We know from experience that the prices of commodities rise and fall over time, responding to the pulls and pushes of demand and supply. Economists thus attribute inflation either to "demand pull" or "cost push". Demand pull inflation mainly comes from expansionary fiscal or monetary policy or from an increase in expenditure from households and firms. With incomes falling and unemployment rising, a rise in aggregate demand is unlikely to have caused the rise in inflation during the pandemic.

Cost push inflation often happens due to increase in wages not justifiable either on grounds of productivity or increase in the cost of living. Such inflation generally happens during high growth periods. This clearly was not the case even according to BBS growth data. Cost push can also come from increased price of strategic inputs such as imported oil or fertilizer or domestic price of electricity.  That too was not the case. So, how can we account for the rise in inflation when both demand and prices of strategic inputs were depressed?

There is a third source known as structural inflation prevalent mostly in the developing countries due to weak institutions and imperfect working of markets. These cause the problem of both shortages of supply, underutilisation of resources as well as excessive demand in some sectors. There is often a huge disparity between what the producer receives, and the consumer pays due to lack of pliable roads, cold chains, information asymmetries and market imperfections. Firms sometimes decide to increase their profit margins and start charging higher prices for their product to capitalize insider information on policy changes or imminent shocks. This results in profit push or rent seeking inflation which generally happens when there are few or single business entities controlling the supply of goods or services for the entire market as well as the market regulators.

In popular parlance, this is known as the 'syndicate theory" of inflation.  This is a little misleading because it oversimplifies a rather complex market phenomenon.

Propagation and spiraling

Food inflation raises aggregate inflation substantially when food constitutes 56.2% of the consumption basket.  Aggregate inflation also increases through knock-on effects on non-food inflation caused by the rise in food inflation. These indirect effects on inflation works through inflation expectations, wages, and prices of other components in the consumer price index. Rise in food inflation induces labor to demand higher wages, which raises the cost of production and hence prices of non-food items as well.  This appears to hold in the annual food and non-food inflation data in Bangladesh, not monthly data.

In the short-run, high food inflation can have a negative impact on non-food inflation in an economy where food has a large share in the consumption basket.  Surges in food prices depress incomes and consumption, with the most severe impact felt by the poorest, exacerbating already-high income inequality in the country. Decline in real income causes a proportionately greater decline in consumption of non-food items compared to food (Engel's law), and hence a negative impact on non-food prices. Note that non-food inflation declined from 6.2% in February to 5.2% in November. 

Both international and domestic food shocks affect food inflation. Bangladesh is largely self-sufficient in rice, potatoes, vegetables, and fish.  Domestic production fluctuates considerably due to its over dependence on the weather and inadequate deliberate efforts to enhance agricultural productivity.  Some food items such as sugar, wheat, maize, spices, and edible oil are largely imported. The food supply chain in Bangladesh is highly competitive at the producer end but not beyond.  The intermediaries between the producers and consumers appear to usurp a great deal of market power either because of their own large size or through collusion.

Excessively expansionary macroeconomic policies are infrequent in Bangladesh.  Cost and profit push such as increase in commodity prices and speculative hoarding, are often behind strong and sudden upsurge in the prices. However, the rate of increase in the prices of goods and services in general are constrained by the rate of growth of money supply, other things equal, and not by the rate of growth of the price of a particular commodity no matter how important it is in the consumer basket.  It is not possible for increases in, say, the price of rice to set in motion a general increase in the prices of goods and services without corresponding support from the money supply. Macroeconomic policy response therefore remains important even when they do not cause inflation.

Taming without maiming

In controlling overall inflation, food prices remain important not only because a large segment of Bangladesh continues to be poor and any inflation in food prices hurts them disproportionately, but also because of their knock-on effects. However, the authorities also must pay attention to macro demand management—fiscal and monetary--and look for newer channels of policy action within these policy frameworks. The imperfect inflation control instruments often come with side effects, requiring tricky judgment regarding how strongly these therapies can be administered.

From a monetary policy perspective, it is impossible to mitigate supply shocks. However, if the price movements affect core inflation and inflation expectations, either directly, or through second round effects, central banks have a role. A re-focusing of national policy towards enhancement of investment in domestic food supply chains and food production incentives to improve food supply is warranted. Implicitly therefore, it is important for fiscal policy to support price stability given the challenges persistent supply shocks pose on inflation and in cognisance of the fact that monetary policy tools are limited in addressing supply side shocks.

The management of inflation cannot be reduced to a mechanical problem.  There is no formula connecting what is to be done by the government or the Bangladesh Bank and what will be achieved. Inflation management is one of the most dreaded and the most misunderstood of economic phenomena, particularly in the context of countries like Bangladesh. 

Better understanding needed

Structural maladjustments itself or certain institutional features of the business and regulatory environment could be contributing to inflation persistence and volatility. Inflation may well be a result of a symbiotic relationship between market power and political power. Market power exercised by firms has become central to macroeconomics. Recent theoretical work highlights the importance of the relation between market power and inflation. Market-power can be one force causing inflation, but not the exclusive force that can survive without patronage.

The pandemic has brought new challenges in inflation control. More research is needed to examine the behavior and determinants of realised and expected inflation as the pandemic continues to unfold. Policies that prevent scarring of the supply side can help supply return to normal, thus mitigating supply-driven spikes in inflation even in the absence of lockdowns.