Onions

Inflation is in the minds of many nowadays. The newspaper headlines scream, “Inflation soars to a 14-year high.” “Inflation may remain high until Q3.” “Inflation sizzles to 8.7%.” “Onions put Philippines in a stew over food price inflation.”

How significant a problem is inflation? Will it go away on its own, or do our economic managers have to continue to grapple with it?

Inflation is conventionally defined as a persistent increase in the general level of prices. The critical element in this definition is “persistent.” Transitory or one-time increases do not count. Price fluctuations – rises and falls – can be distinguished from inflation.

Then there is this thing called “headline inflation.” It is the increase in the surveyed price of a basket of consumer goods over the past year. It is the same as the year-on-year inflation data. The month-to-month price changes are often ignored in favor of the year-on-year data. A year-long perspective seems fitting because month-to-month changes can be volatile. This practice also reflects the idea that the essence of inflation is the persistence of price increases.

The headline inflation rate for only one or two months may give too narrow a picture of inflation. For example, the headline rate for January and February was 8.6-8.7 percent. We can compare this with the average of the headline rates for all of 2022, which was 5.8 percent, or with the average for 2021, which was 3.9 percent.

The Bangko Sentral tends to talk about average (headline) inflation for a given year. The economists at the BSP have projected the average inflation for 2023 at 6.1 percent. This projection is above the official inflation target of 2-4 percent.

Yet, another concept that appears in popular discussions is “imported” inflation, which occurs when inflation abroad somehow results in domestic inflation.

Some analysts regard imported inflation as something we just have to accept. This view is only sometimes correct. Local inflation can also reflect the effect of a depreciating exchange rate. The BSP influences the peso’s value against foreign currency through its monetary policy.

In general, an easy monetary policy means a lower interest rate, which exerts downward pressure on the exchange value of the peso. Since the BSP can control its monetary policy, it can, to some extent, limit imported inflation.

Some of the inflation observed in 2022 may be due to the weakness of the Philippine peso, although the currency has since recovered. Today, the peso is at P55/US dollar, an appreciation from its low point last October.

Other aspects of inflation relate to how it works or comes about. Inflation is a tax because it reduces the purchasing power of currency (cash or bank notes). As a tax, it is paid by people who save or hoard money. Note that the central bank does not compensate currency holders during inflation.

Inflation is also a monetary phenomenon — the result of too much money in an economy. I deal with this aspect of inflation further below.

What, then, if any, are the problematic aspects of inflation?

Inflation is generally acceptable if wage and salary levels increase in line with or even faster than consumer prices. Over long periods real wages (money wages adjusted for inflation) tend to rise.

In other words, the purchasing power of workers’ incomes is usually preserved. This reflects two factors. One is technological advance that raises labor productivity. The other is the market mechanism. Laborers who have become more productive can bargain for wage increases.

But in the short run, wages may be fixed or increase too slowly. In this case, there can be a significant fall in the purchasing power of workers’ incomes. This can increase the incidence of poverty in the economy. This can also lead to political unrest as workers seek wage increases. These are not minor problems for our economic managers.

Inflation may also be evidence of “disequilibrium” in a market economy. In such a disequilibrium, we say “excess demand” exists at prevailing prices. Not all who want to buy goods and services can do so. These unsatisfied buyers would offer a higher price until they could find willing sellers. While we would observe an increase in prices, this type of “inflation” does not last because prices would cease to rise when the market reaches equilibrium.

In other words, the market mechanism does not by itself generate inflation in the sense of a persistent price increase. For such persistence to exist, there must be a continuing excess demand. In the language of Economics 101, the demand curve must continue to shift to the right, or the supply curve must continue to shift to the left.

From all this, we can conclude that inflation is not a problem even in the short run, so long as there is no continuing excess demand.
I return now to the question of whether inflation is a monetary phenomenon. The question may be rephrased. Can a central bank be blamed for unwanted inflation?

The answer is a qualified Yes. We now know that monetary policy can be a continuing feature of excess demand. This happens if the central bank adopts a ‘too low’ policy interest rate (see my July 2022 column here at the MetroPost, “Central Banks Under Stress”). But fiscal policy or government spending can also add to continuing excess demand. In this case, the central bank shares only some of the blame for inflation.

There is another more nuanced view of inflation by Olivier Blanchard, formerly the chief economist at the IMF. He sees inflation as “fundamentally the outcome of the distributional conflict between firms, workers, and taxpayers. It stops only when the various players are forced to accept the outcome.” In Blanchard’s view, the referee or umpire of this distributional conflict is, by unhappy default, the central bank.

An overheating economy can be a source of conflict when both workers and firms can raise wages and prices.

Another source of conflict is a sharp increase in the price of imported energy or commodities. The government can help resolve the distributional conflict through subsidies, reducing expenditures, or even “mandates” or controls on wage and price increases. An inflationary spiral can result when the various players cannot settle the distributional conflict. The central bank would then have to tighten its monetary policy at the risk of inducing a recession.

Blanchard, in short, thinks of inflation as the outcome of a breakdown in social cohesion.

In conclusion, inflation is a persistent rise in prices, especially those of consumer goods and services. Such inflation will, however, only exist if markets fail to achieve equilibrium in a situation of continuing excess demand in the economy. Excess demand may be influenced by the central bank’s monetary policy or the government’s fiscal policy. A sufficiently tight monetary policy will help to extinguish inflation. As would restrained government spending. Inflation can nonetheless remain an unwelcome feature of an economy where there needs to be more social cohesion (Blanchard’s view).

_________________________________________________________

Author’s email: ORoncesval4@gmail.com; Twitter: @ORoncesvalles