Monday, June 23, 2008

The Good, The Ugly and The Bad Kinds of Inflation

We all know that the inflation rate that we experience with our wallets is far higher than the official inflation rate, which rose from 2% in 2007 to 3% in the first five months of 2008 and 3.8% in May alone.

Economists know that the national inflation rate is an average inflation rate based on the average spending pattern of an average citizen, who is actually just a statistical entity.

To come up with a more realistic and transparent CPI index, I propose that the government adopt the following measures:

1. An urban inflation rate be measured and disclosed versus a rural/small town inflation rate. We all know that a bowl of noodle costs much less in a small town like Sibu than in PJ/KL.

2. That the government updates the consumer survey on which the CPI is based and which may no longer be relevant because the last survey was done years ago.

3. That the government reveals how much of the average cost of food for the consumer is imported so that we know whether a stronger Ringgit will help to keep a cap on imported inflation.

4. That the government and Bank Negara educate the public about the linkage between cost-push inflation and demand-push inflation. BN always say the two types of inflation are different but the truth is that cost-push can lead to demand-pull when expectations are anchored that food and oil prices will continue to rise. The worst type of inflation is galloping inflation caused by the people's diminishing faith in the Ringgit.

5. That the real reason for rising inflation (not the national average CPI) is partly because there is excess money in the system created by a managed currency policy. 101 Economics tells you that too much money chasing after too few goods leads to higher prices. Hence, letting the Ringgit appreciate will curb money creation and dampen inflation.

In conclusion, good inflation (e.g. 3%-4%) occurs when prices rise due mainly to higher costs and there is little people can do anything about it except to buy less of the item and switch to a cheaper subsitute. Bad inflation (e.g. 4%-7%) occurs when prices rise due to higher consumer demand (e.g. people will buy more when their incomes are higher or they feel richer because of their stock/property investments). Ugly inflation (e.g. 7%->10%) occurs when prices rise due to a complex combination of higher costs, higher demand, wage pressures and worst of all, spiralling expectations that the domestic currency's purchasing power is declining by the day.

Across Asia, Indonesia, Thailand, Singapore, China and India have just entered the start of the ugly inflation phase and that is why their stock markets have been badly hit. Vietnam is already in the deep end of ugly inflation with prices rising by 25% in May.

To avoid bad inflation, governments have to take concrete and pre-emptive steps when the good inflation phase enters the bad inflation phase. Measures such as higher real interest rates, removal of subsidies and currency appreciation will send a strong signal to everyone that long-term price stability is more important than short-term economic growth.

Thus, the government's current strategy of price controls are inadequate short-term measures that encourages people to consume more of fixed priced goods, eventually resulting in more dire shortages in the future. What is the point of keeping prices low for a few years only to find that in five years' time, there is a looming shortage of that controlled item? Isn't the lesson of our petrol subsidies enough to teach consumers and policy makers about the folly of making short-term gains in exchange for long-term problems?
This is why the fuel price debate as highlighted by Malaysiakini is not over yet and needs further analysis by all members of the House.
(Postscript: Good news! A televised fuel debate between PR/BN on 15 July and the government is looking into producing an urban-rural inflation index. Perhaps, someone up there is listening to my suggestions.)

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