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Sri Lanka's debate over the inflation rate 01
19 Nov, 2009 07:03:19
By W A Wijewardene
Nov 19, 2009 (LBO) - Inflation is considered public enemy number one when a country is not at war. Since Sri Lanka’s 30 year old war is now over, there cannot be a bigger public enemy than inflation.
Inflation and its Measurement

Inflation is simply the continuous increase in the prices of common consumer commodities over a sufficiently long period of time. To measure these price increases, countries compile consumer price indices regularly by using the market prices of consumer items which an ordinary consumer normally consumes. In Sri Lanka, this is being done by the Department of Census and Statistics by compiling a new price index covering the prices of consumer items in the city of Colombo and the index is called the New Colombo Consumers Price Index or NCCPI. The percentage increase in the index value over the value that prevailed 12 months ago is normally taken as the current inflation rate, though, by definition, inflation is a long term price development.

To prevent the personal preferences or prejudices of index compilers from creeping into the selection of consumer items, the choice of the consumer items is made after conducting comprehensive consumer surveys periodically. This is important because the index measures the prices faced by a typical consumer and not the prices of commodities which the compilers want them to consume or refrain from consuming for whatever the reason.

Inflation Makes People Poorer

All individuals are concerned about inflation because it makes them poorer unless their incomes increase faster than inflation. For instance, if the annual inflation rate is 5% and an individual’s income increases only by 2%, then, he becomes poorer by 3% at the end of the year. Hence, what matters to people is not the inflation rate per se, but whether that rate is higher or lower than the increase in their incomes. Since everyone aspires to become richer over time, inflation rates higher than the increases in incomes are a matter for worrying and concern.

The Poor are the Worst Hit by Inflation

Rich people are in a position to avoid becoming poorer due to inflation by getting their incomes to rise faster than inflation. Anyone visiting a medical specialist or a lawyer will experience that the fees they charge have risen faster than inflation thereby placing them in an advantageous position. This is not the case with the poor people because they do not have ways of raising their income at their own will. Hence, it is the poor people who get hit mostly by inflation.

Governments too Lose from Inflation

A government should be concerned about inflation for two reasons. First, inflation directly jeopardises government’s chance of returning to power, since dissatisfied voters could overthrow it at elections. Second, inflation thwarts the government’s objective of attaining continuous long term economic growth, because it hinders people’s ability and willingness to save, invest and commence businesses that bring them long term returns. Hence, it is always in the interest of the governments to keep inflation at low levels, if they want to remain in power.

This is why governments have mandated independent central banks or monetary authorities to take suitable measures to prevent the inflation from raising its ugly head. In Sri Lanka, this mandate requires the Central Bank to pursue, as a core objective, ‘the attainment of economic and price stability’.

Why Economic and Price Stability?

The term economic and price stability is puzzling, but it requires the Central Bank of Sri Lanka to target a goal beyond maintaining a merely stable level in a price index. It in essence calls upon the Central Bank to maintain stability in the three major markets in the economy: the market for goods and services, the market for money and the market for foreign exchange. Al these three markets are interconnected and if there is any instability in one market, it will affect the other two markets driving them too to instability.

These three markets are governed by three different prices, the goods and services market by the general price level, money market by interest rate and the foreign exchange market by the exchange rate. A central bank cannot stabilise all these prices simultaneously. It could do so only with respect to one price. Hence, if it tries to stabilise the exchange rate, it has to forgo the stabilisation of the other two prices. Similarly, if it tries to stabilise the interest rate, it has to forgo the stabilisation of both the general price level and the exchange rate.

This means, of necessity, its attempt at stabilising the general price level requires it to allow the other two markets to become stable by changing their respective prices up or down appropriately on the basis of whether there is a deficit or a surplus in the market. If these two markets are unstable, that is, if there are deficits or surpluses in them causing interest rates or exchange rate to rise or fall, then, the Central Bank of Sri Lanka is deemed to have failed to fulfil its statutory mandate. Hence, any artificial fixing of either the interest rate or the exchange rate will reduce, to a mere temporary achievement, the Central Bank’s gain over price stability by having a slow increase in a price index.

The mandate of economic and price stability requires the Central Bank to attain a situation where there are no deficits or surpluses in all the three markets and, therefore, no pressure for the respective prices to change upward or downward.

Should the Country be Complacent about Falling Inflation Rate?

In the current context, the much talked about low inflation in Sri Lanka appears to be a development about which the country cannot be complacent.

In the first place, there is a statistical cause for the index to record a slow growth in the current period. This is because 12 months ago, Sri Lanka had the highest inflation rate in the history and the value on NCCPI had risen to a very high level. Compared to that high level, the current value of NCCPI has recorded only a growth of less than 2 %. But, every month, the index value rises by closer to 1 % and, therefore, by this time next year, the index should rise by about 10 – 12 %. So, as the past experience has shown, the slow growth in NCCPI will not become sustainable unless the Central Bank tightens, rather than loosening its monetary policy.

Second, NCCPI has omitted an important segment of the consumers’ basket, namely, alcohol and tobacco, presumably on the ground that the government does not encourage its consumption. Yet, its prices affect the consumers’ cost of living and all decisions relating to saving, investment and enterprise are taken by taking those prices too into account. This type of omissions create a divergence between what the people expect as inflation in the future and what the index presently depicts as inflation.


If the expectations are higher, people will incorporate these higher expectations into wage bargaining they make with the employers. The current demand for wage increases ranging from 20% to 75% indicates that the people have formed higher expectations about the future inflation. Similarly, savers too will demand for higher interest incomes, when they place their savings in bank deposits and contractors will ask for higher prices for goods they promise to deliver in the future.

Third, the low growth of exports and the presence of a deficit in the current transactions in the balance of payments which has to be filled by short term borrowings indicate that the foreign exchange market is not in stability. The country’s past high inflation has made its exports uncompetitive and the maintenance of a fixed exchange rate during that period has worsened the situation in the foreign exchange market. At present, the oversupply of foreign exchange in the market due to short term borrowings has prevented the exchange rate from falling. But, it creates a situation known as the ‘Dutch Disease’ where short term foreign exchange receipts causing the exchange rate to become stronger will displace the country’s traditional exports. This is already evident by the cry of exporters for export subsidies and currency depreciation.

Fourth, the artificial fixing of the lending rates of the state banks by the government has destabilised the money market. The low lending rates will encourage the borrowings raising money supply and creating an artificial demand for goods and services. It will influence the general price level to increase in the future. On the other side of the coin, the reduction in the deposit rates will cause the savings to dry up and make it difficult for the economy to generate the required volume of savings for investments. It will also upset the government’s borrowing plans from the private sector which does not have savings. Hence, for the country to maintain the required economic growth rate, the country will have to finance the investments by issuing new money, thus adding another cause for the inflation to raise its ugly head in the years to come.

Hence, the current low increase in the NCCPI is not a matter for complacence at all.

The writer is a retired deputy governor of the Central Bank of Sri Lanka. To read previous columns in the series go to the WatchTower section on the main navigation panel or click on the links below.

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10. W.A Wijewardena Nov 23
To CA-MANCH @ 4:
The depreciation of exchange rate could have a one time influence on the index to the extent the index covers the imported goods in its composition. In NCCPI, this is about 35%.

But for it to become inflation, it has to be validated by an increase in MS. This is because prices are determined both by the demand and supply. The rise in the prices of imported goods will reduce the aggregate supply, but if the aggregate demand does not rise, it cannot continuously increase the general price level. So, the basic culprit of continuous inflation is not the AS but AD.

Your other two arguments are perfectly correct and the impact of interest rate changes too could be incorporated in the price index. But, these rate changes should be determined by the market and not by government fiat which is similar to a price control. It does not affect the index but continues to aggravate inflationary pressures.

9. W.A Wijewardena Nov 23
To Harsha @ 5:
I am willing to believe that learned Brian Aitken has been misquoted by media.

If not, the argument collapses on itself.

Inflation is caused not by real demand but by monetary or nominal demand. If someone wants to learn the price he has paid per unit, all he has to do is to divide the money expenditure by the real number of units purchased. Similarly, the general price level is determined by the nominal demand created by the increases in money supply which has not been moderated by increases in the demand for money.

The present situation is very precarious.

The real output is below the potential level, so the aggregate supply is lagging. Government's domestic borrowings from the banking system have been replaced by external borrowings leading to an increase in the net foreign assets and a consequential increase in money supply. Already M2b is rising at 15% p.a. The reduction in lending rates will encourage the private sector to increase its borrowings which were negative three months ago.This will further increase money supply. The reduction in deposit rates as a consequence of a reduction in lending rates will reduce the demand for deposits and encourage consumption thereby raising the nominal aggregate demand which has already risen due to increases in money supply.

So your total money expenditure is higher and the total real quantity you have is lower, so the general price level will have to give way by moving upward. So the inflationary pressures are higher and it will not be reflected by the price index which does not take into account all the goods a typical consumer consumes.

But, my contention of an acceleration of inflation rate by this time next year was on the ground of current average monthly inflation of closer to 1% which makes up a compound rate of 10-12% if not checked by tighter monetary policies.

It is like a physician who has abandoned the treatment because he has got a wrong laboratory report on the condition of a patient.

8. Rohan Samarajiva Nov 22
"To prevent the personal preferences or prejudices of index compilers from creeping into the selection of consumer items, the choice of the consumer items is made after conducting comprehensive consumer surveys periodically. This is important because the index measures the prices faced by a typical consumer and not the prices of commodities which the compilers want them to consume or refrain from consuming for whatever the reason."

This unequivocally supports the reinstatement of alcohol and tobacco products among those included in the Index. I hope the professionals at the Department of Census and Statistics and the Central Bank will continue to argue for this. Now that inflation is "down" the chances are winning the argument are better than when these items were removed from the Index.

As always, a cogently presented column. Thank you.

7. harsha de silva Nov 21
Mr Wijewardene
according to lbo dr brian aitken of the visiting imf delegation has said yesterday that "output is below potential so there would be no demand driven inflation".

elsewhere in other newspapers it was reported that they are happy with the situation and are calling for further easing of monetary policy.

ignore the 'demand driven' part of the quote, but how does one reconcile this (no chance for inflation) with your view that inflation may rise to 10-12 percent next year?

thanks harsha

6. W.A Wijewardena Nov 20
To CA - MANCH @ 3:
You are correct.

Central bankers should be conservative and cautious in their approach to policy. They are like a physician who has observed some progress in the recovery of a patient and does not want to change the course of the treatment until he has fully recovered.

Besides, you may recall that the Polish Economist Michal Kalecki observed as far back as 1943 that inflation cycles very closely correspond to the political cycles. That is, those in power would try to return to power by taking very popular policies, through inflationary means, of creating jobs artificially and reducing the inflation again by price controls or subsidies just before elections. But after the elections, inflation resurges and rises to a high level. Though Rational Expectations theorist had found evidence of mixed results, Kalecki's observations are valid for developing countries.

5. Ralph Nov 19
Would be nice if someone organization in SL kept an independent index, independent of the fiddling by govt. w.r.t what constituents of the index.

also would be nice to compare the core inflation with SLCPI as well.

Basically the inflation # has to give a fair representation of the price of goods - as far as i can see, the prices of a lot of things are still 'Gini Ganang'.

Fuss, no articles in a while?

4. CA-MANCH Nov 19
My other question is about the general price level. About the three price levels in the three markets, doesn’t a consumer price index account for the movements in the exchange rate by including imported goods in the basket?

Also, many economies account for the movements in the interest rate by including mortgage costs in the CPI basket. If this approach is taken, i.e., stabilising a broader “general price level”, doesn’t the interpretation of price stability become less complex?

3. CA-MANCH Nov 19
Thank you for this. The advanced economies are battered by business cycles, whereas Sri Lanka suffers from “inflation cycles”. Have we been too hasty in loosening monetary policy when inflation starts to fall, and too slow in tightening when inflation starts rising? Aren’t we about to experience the haste once again?
2. mw Nov 19
Another clearly written article. Now I clearly understand the impossible trilogy.

Looking forward to your next article.

1. fuss-budget Nov 19
Read this very carefully, several times.

"But, every month, the index value rises by closer to 1 % and, therefore, by this time next year, the index should rise by about 10 – 12 %. So, as the past experience has shown, the slow growth in NCCPI will not become sustainable unless the Central Bank tightens, rather than loosening its monetary policy. "