Finance & EconomyLeaders

  HEATED CONTROVERSY OVER INFLATION

Most governments now accept that low inflation is essential for sustainable growth, and not, as was once thought , an alternative to it. The trade-off between a bit more inflation and a bit less unemployment can still be made in the short term. But experience has shown that attempts to apply it in the long-term do not work. They simply result in ever-rising inflation. Sequel to this ,some analysts believe   inflation should be kept  low. But   how low?  Is 5% inflation acceptable? Is 3% better than 5%? Is zero inflation best of all  ?

Answers to the above questions remain subjects of heated controversies . While some analysts believe keeping inflation low is desirable and appropriate ,some believe price  stability and volatility are equality critical issues that governments and regulators must consider not only keeping it low ; price stability and volatility ,they claim , are equally damaging when out of control as its level or rate .The Governor of the Central Bank of Nigeria, CBN, Godwin Emefiele , has been on it for long ,finding answers to resolve and tame the orgy of inflation with its cancerous impacts on the economy ,yet it remains a hard nut difficult to break .

There is no doubt that keeping inflation low is eyed by many governments and  this is confirmed  by our investigations on this heated subject . Several governments set their inflation targets of 2% or less in line with the above thinking in the 90s . The Reserve Bank of New Zealand, probably the world’s  most independent central bank, aimed for 0-2% by the end of 1993. At that time , the   bank of Canada  targeted  2%;   at the same point in time ,the Bank of Japan and the Bundesbank both had  medium-term goals of no more than 2% at a time . Britain Treasury once   announced a target of 1-4% for the few years and 2% or less in the long-term during the same period . But  the  governor of the Bank of England at that period was said to equally  plan  and favour  price stability.

These ambitions may sound strange to modern ears.  Since the early 1930s, prices in industrial economies have risen almost every year; by a total of about 1,000% in America  and 4,000% in Britain. Yet, through history, inflation in the sense of continuously rising prices has been the exception, not the rule. Bursts of sustained inflation occurred during the Roman Empire, the Middle Ages and the reign in Englant of Queen Elizabeth I; but, between, prices remained broadly stable over long periods. Short periods of rising prices were interspersed with years of falling prices. The average price level in Britain in the early 1930s was no higher than in the 1660s.

With that scenario above, opinions are divided among analysts. Some prefer price stability to the clamour for keeping inflation low by others     . Those who favour a return to price stability argue that it would make possible the fastest long-term growth. Their critics either believe that a little inflation is healthy or argue that the costs of reducing inflation to zero are greater than the costs of inflation itself.

What’s wrong with inflation

What are those costs of inflation? If the rate of inflation were perfectly predictable, then most of the ill-effects could be avoided. Contracts, wages, interest rates and the tax system could take future inflation into account, and it would make little difference to economic performance whether the rate was 0% or 5%. It is because inflation is not predictable that it damages economies.

Unforeseen inflation stunts growth because it distorts the price mechanism  by making it difficult to distinguish changes in relative prices from changes in the general price level. If apples are rising in price relative to other fruit, this ought to attract new apple-growers and encourage consumers to buy plums instead. But general inflation obscures that relative movement: neither housewife not fruit-grower takes much note of a 20% jump in apple prices, when even plums have gone up 15%. So resources are misallocated, and growth is consequently slower. Even with just 5% annual inflation, prices double every 14 years, swamping most relative price changes. If the general price level were stable, the market economy would function better.

The second effect of inflation is uncertainty, the enemy of investment and growth. If businessmen are unsure about the future level of prices, and hence of real interest rates, they will be less willing to take risks and to invest, especially in long-term projects. Inflation encourages a preoccupation with short-term profits at the expense of longer-term returns. Furthermore, uncertainty about inflation pushes up real interest rates, as lenders demand a bigger risk premium on their money.

These arguments suggest that in a real world that cannot foresee the future the best inflation rate is the one that plays the least role in decision-making. This must be zero; anything higher will generate unnecessary uncertainty and inefficiency.

Yet some people dont worry

Some economists disagree. They argue that if uncertainty is the real trouble with inflation, then the volatility of inflation is more important than its level. An inflation rate that averaged 0% but fluctuated between plus 5% and minus 5% would be just as damaging, they argue, as one that averaged 10% and swung between 5% and 15% . Their conclusion is that policy-makers do not need to eliminate inflation but merely to stabilize the rate, to make it easier to predict and so less harmful.

In fact, however, over the past 30 years the countries with the lowest inflation have also had the most stable inflation rates  according to a report published in the 90s . It seems to be easier to stabilize inflation at low levels, partly, perhaps, because this creates virtuous circle of low inflationary expectations.

Larry Summers, the former  chief economist at the World Bank, once  argued that 2-3% inflation is best. His first reason was that it leaves open the possibility of negative real interest rates, which could help to pull an economy out of depression. With zero inflation, real rates cannot be negative: lenders would be paying borrowers to borrow. Second, a little bit of  inflation acts like a lubricant, helping relative prices and wages to adjust more efficiently. Trade unions in declining industries may resist a cut in nominal pay, yet be paid wages. With zero inflation this safety valve would be locked, resulting in job loss and possibly greater labour unrest.

A counter-argument to this is that, while inflation keeps ticking, the inevitability of annual (or, at best, triennial) pay-bargaining rounds strengthens the position of trade unions. Were prices stable, wage increases would be justified only by a rise in productivity or by individual performance. So unions would play a weaker role, making industrial unrest less likely.    This is confirmed by the fact that  high-inflation countries are more strike-prone: the higher the inflation rate, the more frequent wage negotiations need to be, so increasing the risk of strikes.

Arguments for zero inflation, however, ignore one basic statistical point: the most commonly used measure of inflation, the consumer-price index (cpi), is often inaccurate. So could a bit of inflation, as measured by the CPI, be acceptable?

There are two reasons why the CPI exaggerates inflation. First, it fails to adjust fully for improvements in quality. A typical 1992 car costs much more than did a 1982 car. But it is a much better vehicle. Second, and more technical, the weights used to add together the prices of the different goods and services that go into the index are often out of date. This exaggerates the increase in the cost of living, since it does not allow for the fact that consumers shift from goods, which become relatively expensive to cheaper alternatives. If apple prices, say, multiply twenty fold, few apples will be eaten. Apple should then barely figure in the index at all. But they will, often for many years. The weights used today in Americas CPI are based on the spending patterns of  years ago

Robert Gordon, an economist at North western University, Illinois, once  estimated   that Americas CPI has overstated the rise in the prices of consumer durables   over the past couple of decades.  The exact size of the upward bias will vary from country to country. But it is one reason why central banks tend to define price stability as an annual rise in the CPI within the range of 0-2%, rather than zero.

If policy-makers aim for literally zero inflation, as measured by the CPI, they may end up pursuing an overly tight policy, for this would-in practice-imply falling prices. And these two have damaging effects. Just as the expectation of rising prices encourages people to buy now, not later , falling prices cause consumers to spend less, because the return from holding goods. In periods of inflation, there is a self-correcting mechanism: nominal interest rates rise with prices, encouraging consumers to hold money. But the process cannot work in reverse when prices are falling, because interest rates cannot, in practice, be negative. So it will remain more attractive to hold money than goods, and the demand for goods- and hence their prices will continue to fall.

Governments should not conclude from this, however, that because an apparent inflation rate of 2% really means price stability, they can turn a blind eye to it. The CPI itself influences wage-and price setting. If it continues to rise, countries will be denying themselves the full benefits of price stability. The lesson for governments is that they must devise more accurate price indices.

From theory to fact

Despite all the theoretical reasons why inflation is bad for growth, the empirical evidence is rather spare. True, the global slowdown in growth in the 1970s coincided with a surge in inflation. But was the rapid expansion in the 1950s and 1960s due to the modesty of inflation at the time? It can also be explained by other factors, such as the post-war catch-up in industrial investment and the liberalization of world trade.

Do countries with high inflation have slower or faster growth than those with low?  The answer I not clear cut.  In 1955-73 (i.e. when inflation was modest, it looks as if growth and inflation went together: countries with the highest inflation tended to have the strongest growth in GDP per head. That correlation, however depends heavily on Japan, which had both the highest average inflation rate (5.8%) and the strongest growth (8.6%), Excluding Japan, there is little relationship between inflation and growth.

Since 1973, in contrast, low inflation countries have tended to enjoy slightly faster growth. In countries where inflation averaged less than 6%, growth per head averaged less than 6%, growth per head averaged 2.1%; in those with inflation of 6-10%, that growth was 1.9%; and where inflation was above 10%, it averaged 1.7%.

There were four main exceptions to this rule: Ireland, Italy, Spain and Switzerland. The latter grew by a paltry 1.1% a year in 1974-91, despite having the second lowest inflation rate of 2.0%. At the other extreme, Italy, Spain and Ireland all enjoined strong growth, despite inflation rate of more than 10%.  Herein lies a clue to why the link between inflation and growth appears to be weak. Among the 20 countries, Italy, Spain and Ireland at the start of the 1970s had by far the lowest income per head. So they had plenty of room to catch up, and enjoyed faster growth in their productive potential than other countries just as Japan did in the 1950s and 1960s. Switzerland, the richest country, had less scope for growth.

Another factor which may have blurred the relationship between growth and inflation is the way that expectations of inflation lag behind events. After decades when prices were expected to remain broadly stable over long periods, future inflation was persistently underestimated between the 1950s and 1970s. This resulted in abnormally low real interest rates. In theory, countries with high, and hence more variable rates of inflation should have had higher real interest rates; in practice, their average real interest rates were lower, which boosted their growth rates.

For example, if industrial economies are split into three groups according to their rates of inflation, then during 1974-83 real long-term interest rates averaged 2.1% in the countries with the lowest inflation, 1.2% in those with medium rates of inflation, and were actually negative in those with the highest inflation.

But this trick could not be repeated, for financial markets will not be cheated a second time. From 1984,   high-inflation countries have had higher real interest rates than low-inflation countries, making the adverse consequence of inflation far more severe than they were in earlier years.

Link Between Inflation and Unemployment 

The link between inflation and unemployment is a much clearer story. During 1974-91, countries with low inflation had the lowest jobless rates. This is not to deny that the process of reducing inflation pushed unemployment temporarily higher in some countries. But, for the period as a whole, low inflation was not achieved through high unemployment; if anything, it favoured job-creation.

Some more sophisticated econometric studies have tried to disentangle the effects of the many factors that influence growth. One study by two economists at the Bank of Canada, covering 62 countries over 25 years, concludes that a reduction in the inflation rate by one percentage point increases the annual growth rate by one-tenth of a percentage point. A recent OECD study reaches a similar result. That may seen piffling, but over time it adds up. If a country cuts its inflation rate from 5% to 0% say, then in 20 years its output should be 10% higher than it would otherwise have been.

Is worth it?

Assuming that the benefits of moving from 3% to 0% inflation are no less than those of moving from 6% to 3% (they should in fact be bigger, since price stability will eliminate many unproductive activities), then the issue of whether it is worth aiming for price stability benefits exceed the short-term costs.

Price stability may, in theory, maximize economic growth in a long-run steady state. But there are short-term costs in getting from here to there. To reduce inflation, unemployment must temporarily be held above its so-called natural rate (the rate consistent with stable inflation), and the short-term loss in output and jobs will initially offset the benefits. For example, growth might need to be reduced by one percentage point for one year in order to reduce inflation by one point. Applying those estimates from the Bank of Canada economists, in this case it will take ten years before output reaches the level where it would have been if nothing had been done. If the cut in growth needed is only half as great, it will still take five years.

Over a 20-year period, the economy as a whole would certainly gain. The snag is that governments are in power for only four or five years, and todays workers care far more about jobs today than prosperity in 20 years time. The risk is that policy-makers will conclude that a bit of inflation is not so bad after all as the British government now appears to have done.

The transitional costs of moving to price stability arise because expectations are slow to change, and because large parts of the economy are built on the assumption of continuing inflation. Workers expect annual pay increases roughly in line with last years inflation rate. Home-owners may have borrowed heavily to buy a house in the expectation that inflation will erode the real weight of their mortgages; if inflation suddenly falls, they are struck with a burden of debt bigger than they expected.

Likewise, just as some of the damage to economic growth from inflation was muted in the 1970s by negative real interest rates, as expectations lagged behind actual inflation falls, real long-term interest rates will rise and stay high until investors believe price stability has come to stay.

A   study by Stephen King, an economist at James Capel, a London Stock broking firm, concludes that zero inflation is currently an impossible goal for some countries. The short-term costs of disinflation, he argues, will prove too great, and a prolonged slump will force policy-makers into longed slump will force policy-makers into reverse. Attempts at price stability will fail, unless certain preconditions are met: in particular, private-sector debt must be at a sustainable level, and the labour market must work efficiently, with flexible wages.

Mr. King ranks the six big industrial economies  according to whether they meet these preconditions. He concludes that industrial economies according to whether they meet these preconditions. He concludes that only two of the six, Germany and Japan, can cope with disinflation. Elsewhere, he fears that excessive zeal in crushing inflation could prove self-defeating. British looks least able to cope, thanks to its rigid markets, high debt burden and stubborn inflationary expectations.

Yes, if governments cut the cost

The real lesson from this, however, is not that governments should immediately abandon their fight against inflation, but that they must put more effort into reducing the short-term costs of the fight. Tight monetary and fiscal policies are not enough: to reduce the cost of disinflation, governments must wean firms and workers off their inflationary habits and tackle the institutional rigidities that keep inflation going.

This also underlines the importance of making anti-inflationary policy fully credible, to reduce inflationary expectations and thereby minimize the loss of output needed to carry them through. The first priority is to remove from politicians the temptation to give the economy a short term stimulus, by removing the means: i.e. by making central banks independent.There is evidence that the greater independence won by central bank in New Zealand and Canada in recent years, combined with explicit inflation targets, has helped to dampen inflationary expectations and to hold down wage demands. Both countries have reduced inflation to around 1%, albeit at the cost of deep recessions. New Zealand is at last starting to enjoy the rewards: output has grown by almost 4% over the past 12 months and most economists are forecasting rapid growth over the next few years.

Zero inflation is not the instant, miracle cure that some proclaim; its benefits are long-term in nature. Unless governments reduce the short-term cost of inflation-fighting by attacking supply-side rigidities, the goal will remain elusive. But the sooner governments can convince individuals and firms that they are committed to price stability, the sooner the economic rewards will follow

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