In­fla­tion dy­nam­ics and its ef­fect on econ­omy

New Straits Times - - Business - The writer is the Pro­fes­sor of Eco­nom­ics at Sun­way Univer­sity Busi­ness School and Di­rec­tor of Eco­nomic Stud­ies Pro­gram at Jef­frey Cheah In­sti­tute on South­east Asia at Sun­way Univer­sity. He is also an ex­ter­nal mem­ber of Bank Ne­gara Malaysia’s Mon­e­tary Poli

AF­TER nearly two years of low con­sumer prices and fall­ing pro­ducer prices, their steady rise in the first quar­ter of this year sug­gests that higher in­fla­tion and price shocks will once again test the re­silience of house­holds, busi­nesses and the over­all econ­omy.

While con­sumer price in­fla­tion edged up 4.3 per cent in the first quar­ter, up from 1.7 per cent in the pre­vi­ous quar­ter and 3.4 per cent in the same quar­ter last year, the pro­ducer price in­dex (PPI, which mea­sures the sell­ing prices of do­mes­tic pro­duc­ers), shot up by 10 per cent from three per cent in the pre­vi­ous quar­ter and neg­a­tive 4.4 per cent in the pre­vi­ous year’s first quar­ter.

Mean­while, the broad­est mea­sure of price changes for the econ­omy, the gross do­mes­tic prod­uct (GDP) de­fla­tor, which fell by 0.4 per cent in 2015 be­fore edg­ing up to 1.9 per cent last year, is also point­ing to the ris­ing price pres­sures, with the fourth quar­ter of last year show­ing an in­crease of 2.8 per cent com­pared to av­er­age an­nual in­crease of one per cent over the last five years.

End of low in­fla­tion era? Un­less ad­vanced economies are able to sus­tain higher growth, con­sumer price in­fla­tion in th­ese coun­tries will re­main sub­dued and be­low the two per cent tar­get. Con­se­quently, their role as a part of the global fac­tors con­tribut­ing to in­fla­tion in de­vel­op­ing economies will re­main be­nign over the next few years.

Given am­ple global pro­duc­tion ca­pac­ity and sup­plies, the low in­fla­tion in ad­vanced economies will end only when do­mes­tic de­mand surges more strongly.

De­mand has been held down by per­sis­tent un­em­ploy­ment, age­ing pop­u­la­tion, weak pro­duc­tiv­ity growth and cau­tious sen­ti­ment amid on­go­ing geo-po­lit­i­cal un­cer­tain­ties.

Nev­er­the­less, the more pos­i­tive and syn­chro­nised growth glob­ally that marked the start of this year is a healthy sign that global de­mand may be on a more sus­tain­able up­ward tra­jec­tory that could her­ald a mod­est in­fla­tion en­vi­ron­ment.

In­fla­tion trends in emerg­ing

economies

The low in­fla­tion phe­nom­e­non like­wise char­ac­terised many coun­tries in the de­vel­op­ing world. Al­though there were bouts of in­fla­tion surges due to en­ergy and food price shocks caused mainly by sup­ply dis­rup­tions, the over­all in­fla­tion rate quickly re­verted to the mean for most coun­tries.

So far, the fuel and food com­mod­ity shocks have proved to be tran­si­tory with the un­der­ly­ing in­fla­tion for most economies re­vert­ing to be­low his­tor­i­cal trends. This low in­fla­tion per­sis­tence has been one of the key fea­tures of de­vel­oped and de­vel­op­ing economies com­pared with in­fla­tion per­for­mance in the past decades.

A ma­jor fac­tor con­tribut­ing to low in­fla­tion in emerg­ing coun­tries, in­clud­ing Malaysia, has been glob­al­i­sa­tion. The rise in glob­al­i­sa­tion has cre­ated pos­i­tive in­cen­tives for pol­icy makers to main­tain pru­dent mon­e­tary and fis­cal poli­cies that kept in­fla­tion in check.

Sim­i­larly, trade open­ness has re­sulted in the de­cline of price lev­els as pro­duc­ers be­come more ef­fi­cient. Cheaper im­ports also sub­sti­tute more costly lo­cal goods and ser­vices.

The deep­en­ing of do­mes­tic fi­nan­cial mar­kets like­wise has en­abled the economies to ab­sorb larger trade bal­ance deficits and sur­pluses, thereby re­duc­ing the ef­fects of do­mes­tic sup­ply and de­mand im­bal­ances on prices. How se­ri­ous is the re­cent in­fla­tion surge?

The phe­nom­e­non of weak in­fla­tion per­sis­tence sug­gests that Malaysia’s above trend CPI in­crease in the first quar­ter is ex­pected to ta­per off in the sec­ond half of this year and nor­malised to the two-three per cent level next year in line with ex­pected de­cline in world oil prices.

The mean-re­vert­ing in­fla­tion be­hav­iour is con­di­tional upon sta­ble in­fla­tion ex­pec­ta­tions whereby there are lit­tle knock-on ef­fects on the broader ar­ray of goods and ser­vices in the econ­omy.

The ab­sence of sec­ond or third round price ef­fects ap­pears to be hold­ing up as the un­der­ly­ing in­fla­tion as mea­sured by the core in­fla­tion in­dex thus far has re­mained well-an­chored while de­mand-pull price pres­sures re­mains sub­dued.

On the con­trary, the price pres­sures faced by do­mes­tic pro­duc­ers re­main a con­cern, not­with­stand­ing the fact that ris­ing prices may also in­di­cate bet­ter pric­ing power and top line sales per­for­mance for sup­pli­ers.

A closer look at the dis­ag­gre­gated prices shows that the in­creases were largely ac­counted for by the sharp rise in the prices of raw ma­te­ri­als and in­ter­me­di­ate prod­ucts.

The profit mar­gins of in­di­vid­ual pro­duc­ers, there­fore, will be de­ter­mined by the ex­tent their pro­duc­tion is af­fected by the rise in in­put prices, the abil­ity to pass through the cost in­creases and the ben­e­fits they can reap from higher pro­duc­tion and pro­duc­tiv­ity gains.

For con­sumers, the ex­pected down­trend of head­line in­fla­tion from April on­wards is pos­i­tive news, but of­fers lit­tle con­so­la­tion to house­holds fac­ing stag­nant wages or in­come.

For ex­am­ple, a three per cent an­nual in­fla­tion over five years will re­sult in a 16 per cent de­cline in the real in­come or pur­chas­ing power if there is no ac­com­pa­ny­ing rise in nom­i­nal in­come.

While the to­tal num­ber of house­holds fac­ing stag­nant wages con­tinue to shrink, it is im­por­tant that more tar­geted mea­sures are in place to mit­i­gate the neg­a­tive ef­fects of in­fla­tion even at low lev­els on the af­fected house­holds.

The more pos­i­tive and syn­chro­nised growth glob­ally that marked the start of this year is a healthy sign that global de­mand may be on a more sus­tain­able al­beit grad­ual up­ward tra­jec­tory that could her­ald the be­gin­ning of a mod­est in­fla­tion en­vi­ron­ments.

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