MEASURING inflation accurately is vital to policymakers. The SBP designs monetary policy in accordance with the expected inflation rates along with other determinants. When banks lend money, lending rates are adjusted with inflation rates, T-bills’ (treasury bills issued by the SBP in Pakistan) rates move with inflation rates. In Pakistan, the Federal Bureau of Statistics (FBS) calculates and releases four different price indices to measure inflation.
Most widely used and quoted index is the Consumer Price Index (CPI). CPI covers retail prices of 375 items in 35 major centres and shows the cost of living in urban area of Pakistan. The Wholesale Price Index (WPI) is used to calculate price changes of a basket of 425 items at wholesale level prevailing in the cities of origin of the commodities. The Sensitive Price Indicator (SPI) measures changes in 53 kitchen items consumed by low-income households whose monthly income is up to Rs3000.
Not all organizations in Pakistan use CPI data to index wages. In the West, CPI is used not only to index wages but index pensions and social security benefits as well. Further the CPI data helps governments to adjust government fees and charges, the adjustment of payments in commercial contracts, and for formulating and assessing trade and exchange rate policies.
Inflation may be driven by demand or supply. In demand pull inflation, prices go up as demand increases. Demand goes up due to increase in spending of households. But why spending goes up? Maybe because of increase in employment level or reduction in taxes, which leaves more disposable income in the hands of consumers. As income levels rise, consumers tend to spend more.
With given level of production, firms find it hard to meet the demand in the short run that creates a gap between demand and supply. When there are more buyers than sellers, obviously prices tend to go up-hence demand-pull inflation occurs.
Policymakers have been claiming that easy monetary policy adopted by the SBP over the years provided liquidity in the market and credit to the private sector increased to Rs370.1 billion (July-March 2004-05) as compared to Rs244.6 billion during 2003-04.
The manufacturing sector absorbed 41 per cent or Rs150.8 billion of the net total credit expansion. Economic Survey 2004-05 states that consumer loans amounted to Rs32 billion and personal loans Rs27.4 billion and housing finance Rs14 billion.
But at the same time, in an overheated economy, interestingly, the tax to GDP ratio kept on declining indicating rich made more money and paid less tax to the government and for poor it was vice versa.
Too much money in the hands of the rich was chasing too few goods. It also reflects that our policy makers didn’t correctly anticipate if the economy has the capacity to meet the sudden rise in demand. Mismatch between production, demand, and credit expansion fuelled already cost-push/supply- shock driven inflation.
Cost-push inflation occurs due to increase in costs of production. Costs of production refer to those costs which are being paid by the firms in the form of wages, rents, taxes, insurance, raw material, etc. to produce their products. Any increase in costs of production will lead to increase in prices of goods and services.
With a given level of income of consumers, purchasing falls. Also with increase in costs of production, the current businesses would need more cash to buy factors of production, hence it is assumed that not all businesses would survive under the period of stress. Some of them would simply pack up their stuff and would leave the market quietly. As number of manufacturers decreases, the quantity supplied moves downward indicating fall in supply and price level.
In Pakistan, the economy is witnessing both supply driven (in the form of increasing costs of production) and demand driven inflation (excessive credit expansion).
Increase in oil prices in the international market which has peaked to $70 per barrel has been one of the major factors contributing to the rise in inflation.
Greed of hoarders of cement, flour, sugar, etc. added fuel to supply shock inflation. Real estate mafia has created likely-burst-bubble sending prices of real estate through the roof. The economy therefore is witnessing simultaneous supply shock and demand pull inflation which is not desirable by any standard.
Monetary policy has taken a U-turn now to limit credit to the private sector and inflation-remains to be seen when current financial years close if the tight monetary policy has been effective.
Increasing inflation makes businesses more expensive to operate. Businesses raise their prices to beat any rise in costs of production-hence inflation occurs. With given level of income, households find it hard to buy goods and services at higher prices. As their buying power erodes they tend to spend less. Revenues to the businesses may fall and government collects less in terms of business taxes.
Price stability remains one of the most important objectives of any government. Abnormal behaviour in price pattern would lead to uncertainty. It hampers both growth and consumer spending. Investors make plans keeping in mind the interest rates, which are very much linked to price level. When prices are stable and inflation is anticipated, investment decisions become much easier. When inflation is not anticipated but pops up suddenly, investors lose.
If Pakistan’s economy is having four per cent inflation and nominal interest rate is eight per cent, the real interest rate is four per cent. When inflation is anticipated and it is expected that it is likely to increase to 4.5 per cent in the next fiscal year nominal interest rates must also rise to offset any increase. To maintain the same real rate of return, the nominal interest rate must rise to 8.5 per cent. In this case, the lender does not lose.
However, the problem arises when inflation is not anticipated and it occurs at once and jumps to say, 5.5 per cent suddenly. As nominal interest cannot adjust with one keystroke, real interest rates or rate of return tends to fall to 2.5 from 4.5 per cent. In this case lenders are the losers. If prices rise further than incomes, people are worse off.
If the interest paid on savings is less than inflation, the interest earned does not compensate people because the value of their savings is eaten away in the process.
Table I suggests how people (with fixed income) earning Rs5,000, Rs10,000 and Rs20,000 rupees per month were effected over the years due to rise in inflation. People earning Rs5,000 per month, are considered to be low income earners are badly hit by rising inflation if their income has not risen to offset any increase in inflation during 2000-05 period.
Table II shows buying power of Rs1,000 note which has slipped to Rs 825 in 2004-05 almost 17.5 per cent decline in its value when compared to the base period 2000-01.
As shown in Table II, a base period Rs1,000 loses its value by Rs34 in 2001-02, was worth Rs936 in 2002-03 and Rs825 by 2004-05. The analysis further suggests that Rs1,000 note would not buy the same number of units which a buyer used to buy in 2000-01 for Rs1,000 due to inflation. Besides, private economists are of the opinion that official inflation figure is understated. The actual figure may be more than that, given the ground reality and problems in the measurement of inflation.
Salaried class and other fixed income earners like pensioners and savers who invested in government securities were crushed under the heavy sand bag of inflation. Their real incomes in most cases have remained flat or have not increased in proportion to inflation rate.
Indexing wages, pensions and other incomes vis-à-vis inflation remains a disappointing phenomenon in Pakistan which requires a detailed analysis on the part of experts and government.
The government must ensure and prepare all private sector and public sector organizations to index wages according to inflation rate every year to maintain living standard of low-middle- income group.
The writer a deputy director SZABIST, Islamabad campus has expressed his personal views.
