Artificially high CPI poses grave risks

Benefits of monetary policy may be undermined

Published: 2011/05/30 07:21:24 AM

AS THE global recovery starts to gain momentum, we can expect increased consumer demand to replace input costs as the primary driver behind inflation. Robust growth is welcome, but inflationary pressures need to be monitored to avoid the damaging effects of entrenched inflationary expectations that could lead to soaring labour costs. Expansionary monetary policy increases the money supply and it is only reasonable that we see increased inflation figures. However, as quantitative easing in the US comes to an end, we can expect inflation to slow down. That said, basic economics tells us prices tend to remain "sticky downwards" prices are quicker to rise than they are to fall. This is especially true with wage negotiations. In theory, an expansionary monetary policy boosts consumer demand, but in turn causes inflation that devalues real incomes. The trouble begins when workers anticipate the effect of increasing inflation on their real income and start to push for increases considerably above the current inflation rate. Growth in the service sectors in the US and Europe hit its highest in five years in February, suggesting economic growth is accelerating. The question is whether the labour market will be willing to absorb the upward pressures on prices created by growth? April figures for the European Union show that core inflation excluding volatile energy and unprocessed food consumer prices - was 1,8% higher than a year ago. This was the most rapid increase in two years. In China also, consumer price index (CPI) figures rose 5,3% from a year earlier. Although this was a percentage point decrease from the month before, it i s still significantly higher than predicted. In the UK, inflation is running at double the Bank of Englands 2% target yet the growth in employment figures suggest that it is probably not strong enough to warrant a similar increase in wages. In SA, external cost-push factors, such as rising food and fuel prices, continue to be primary drivers of inflation figures. Increased electricity tariffs are also a contributor. Inflation is not in the upper range of its 3%- 6% target range yet the latest figure for April is 4,2% but it is expected to breach the 6% upper limit this year. The Reserve Bank predicted that inflation would peak at 6,3% in the first quarter of next year and average about 6% over the year, yet growth is predicted to remain modest at a little more than 3%. The big question when formulating a policy response is whether what is driving inflation is demand-driven or cost-push. The choice by the Banks monetary policy committee (MPC) to keep interest rates stable is not surprising given uncertain current energy prices and expectations that

they might rise in the medium term. A strong rand offers protection from imported inflationary pressures but in the long run will be harmful to the competitiveness of our exports. Raising interest rates too soon will stifle investment and consumer spending leaving it too late can lead to inertia caused by entrenched expectations of future price increases. Inflation can help growth, but there is always a danger of inflationary expectations fuelling rapid inflation, particularly in SA, where a high proportion of the employed labour force is unionised. This will be difficult to rein in. The fact is that, while the decisions made by the MPC may be appropriate given the circumstances, the CPI is only a measure of inflation it does not necessarily reflect the real effects of inflation on the average consumer. This is not to say that CPI or "headline" inflation figures are arbitrary, but that they are potentially no longer representative of the real effect of inflationary pressures given current economic conditions. The problem is that the recession has necessarily changed household consumption patterns. A combination of decreased household income and increased costs of basic necessities food, petrol and electricity means that the CPI no longer measures the same effects that it did when it was last revised in 2006. Current CPI figures are calculated using the weighted average of the prices of a basket of commonly consumed goods and services. Recessionary-related distortions in spending patterns and increased prices mean that the weights chosen in calculating this average are out of kilter with reality. Consequently, the current measure of the CPI is likely to be misrepresentative in its measurement. What is perhaps more worrying is that CPI inflation figures are often the basis of wage negotiations in SA. At the very least, CPI figures are the starting point from which unions and workers begin to make decisions about what sort of increase they will ask for. While it is arguably fair that unions seek to raise the wages of their members relative to other sectors, it certainly isnt reasonable or economically prudent for them to reinforce inflationary expectations. Given that current economic conditions have resulted in inflation figures under-representing the effects of rising fuel, food, and electricity prices, there is certainly a need for more frequent reweighting of the CPI. Moreover, it is reasonable to comment that the Reserve Bank should be cautious about allowing inflationary expectations to become entrenched. The fact is that inflation figures form the basis of union wage negotiations. These are more often than not already astronomically over and above the current inflation figures. A potentially dangerous combination of an inappropriately calculated and high CPI could have serious ramifications in the labour market that would outweigh the investment benefits created by less restrictive monetary policy. CPI figures are the starting point from which unions begin to make decisions about what sort of increase they will ask for