Sunday, May 25, 2008

Making sense on Inflation

Ajay Shah points me to this article on this economist article on Inflation on emerging economies, arguing it bare resembles to the great inflation of developed countries in the 1970s. With inflation of about 25% in Sri Lanka and with the Central Bank more or less claiming that inflation is a petroleum/agricultural phenomenon (as opposed to monetary) it's an article well worth a read.

Here's a few key paragraphs,

Many policymakers in emerging economies argue that serious monetary tightening is not warranted: higher inflation, they say, is due solely to spikes in food and energy prices, caused by temporary supply shocks and speculation. Higher interest rates cannot call forth more pigs or grain. They expect inflation to ease later this year as higher prices prompt an increase in supply (food prices have started to edge down over the past month) and as sharp rises in commodity prices drop out of year-on-year comparisons.

Yes, food inflation is likely to slow later this year; but that does not mean rising headline inflation can be ignored. The synchronised jump in global food prices suggests that there is more to the story than disruptions to supply. Prices are also rising partly because loose monetary conditions in emerging economies have boosted domestic demand. These economies have accounted for over 90% of the increase in global consumption of oil and metals since 2002 and for 80% of the rise in demand for grain. This partly reflects long-term structural forces, but it is also the product of a money-fuelled cyclical boom. Peter Morgan, of HSBC, says that the initial shock to food prices may have come from the supply side, but the strength of income and money growth helps to validate higher prices. Were monetary conditions tighter, rises in food prices might be offset by declines elsewhere, keeping inflation under control. [..]

According to conventional wisdom, the monetary-policy mistakes that caused the Great Inflation are much less likely today because central banks are independent of politicians. But unlike the Federal Reserve and the European Central Bank (ECB), many central banks in emerging economies (notably China, India and Russia) are not fully independent. In another echo of the 1970s, they often face intense political pressure to hold rates low to boost growth and jobs.

Emerging economies are also in danger of repeating the blunder of central bankers in the rich world in the 1970s: they focus on core inflation as a reason for holding interest rates below the headline inflation rate. But negative real interest rates then further boost demand, while rising inflation expectations trigger bigger pay claims. Unless central banks tighten their grip soon, inflationary expectations could surge. [link]

"Core Inflation" has recently become a pet-word for Central Bank Governor, Ajit Nivard Cabraal, and forget "fully independence", Cabraal was one of the key campaign figures in the incumbent president's election in 2005 before being appointed as the Governor of the CB.

So if anyone's serious about CB Independence, then Cabraal needs to be fired. That's a pipe dream, at least until Mahinda Rajapakse remains the president.

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