THE monetary policy statement released on Friday had several notable things to focus on but consider one for now: core inflation. This indicator measures inflation in a basket of goods that excludes food and energy prices, meaning it is largely immune to the supply-side pressures that the State Bank has been blaming for the rising inflation so far.
All year the State Bank has made it a point to mention that core inflation is not showing a rise like food and energy prices are, an observation that allowed it to argue that whatever inflation there is in the economy, it is due to factors like rising oil prices in global markets or temporary shortages of wheat due to a poor harvest. With this argument the central bank could successfully absolve itself of all responsibility to combat this inflation.
For example, back in May the State Bank could say “[w]hile core inflation has picked up in urban areas, price pressures are concentrated among a relatively confined set of items”. Based on this observation they decided no action was necessary by them to bring this trend under control. Then in July after observing that rising oil prices in world markets have substantially been offset by corresponding reductions in tax on the price of petrol and diesel within the country, they said “core inflation also fell over the last two months in both urban and rural areas, confirming the view that the energy and food-driven inflation highlighted in recent monetary policy statements has not seeped into general prices”.
In reality, by this point in time we were well on our way down inflation road. The exchange rate was gyrating madly and the rupee was sliding fast against the dollar. A fall in the value of the rupee imparts a strong inflationary impulse to the economy since ours is a heavily import-dependent economy, especially where energy is concerned, and energy price hikes transmit their effects horizontally to all other goods that are dependent on transport, combustion or electricity, for their valorisation and marketing.
The inflationary tide showed up in a broad range of goods far beyond food and energy.
By September things were beginning to change. “Core inflation also fell in both urban and rural areas in August,” observed the State Bank, before adding, “[n]evertheless, the momentum of prices remains relatively elevated, with month-on-month increases of 1.3 per cent in July and 0.6 per cent in August”. Despite a fall in core inflation the inflationary tide seemed to have breached its more limited confines and was showing up in a broader category of goods. Partially in recognition of this fact, the State Bank raised interest rates by a nominal 0.25pc, ending the prolonged period of “accommodative monetary settings” and signalled further rate hikes to come, albeit in a manner that would be “gradual and measured”.
That apple cart never made it past November, when the State Bank was forced to pull up the date for its monetary policy decision by a week and announce a large hike of 1.5pc in one go. In the statement accompanying that decision, the State Bank was forced to admit that “core inflation has also picked up in the last two months”, showing up in items like “house rents, cloth and garments, medicines, footwear and other components”. The inflationary tide showed up in a broad range of goods far beyond food and energy, forcing the central bank to acknowledge that it could no longer be business as usual.
This creeping trend is characteristic of what happens when inflation is being driven by monetary factors. An expansion in the money supply shows up first as growth, then as exchange rate pressures, then as inflation confined to a narrow segment of goods that are sensitive to exchange rate movements, before it seeps into the overall price level. It can take up to a year to complete this journey, meaning money supply growth today will show up as inflation next year.
That is what has happened here. From a central banking point of view, the situation is somewhat akin to a firefighter who stands and watches as the fire rises, comfortable in the assurance that it is small and manageable, even if he or she can see that the fire is surrounded by combustible material. Waiting for the flames to spread before acting would be folly for that firefighter. Similarly, waiting till inflation has “seeped into general prices” before acting, even as all data shows elevated monetary aggregates and mounting exchange rate pressures, is folly for a central banker.
Central banking is tricky business. First and foremost, the job of a central banker is to watch the money supply, unlike a businessman or a businesswoman whose job is to count the money, more specifically his or her own. The central banker by contrast has to take a panoramic view. Too much money and it will fuel inflation. Too little and it will choke the engines of growth in the economy. Getting the supply just right takes skill, it takes mind and vigilance, and perhaps also a dash of integrity to stand up to the pressures that are pushing you to throw money into the economy to produce a short-lived feel-good factor, since everybody else is only interested in counting their money, not curating the overall supply in the economy.
This is where things went wrong. They sat and watched as the alarms were sounding from May onwards, starting with the sharp slide in the exchange rate, fuelling inflation pressures even further. They moved lethargically in September (but at least they moved) but were still not sufficiently alive to what was actually driving this slide. On Saturday morning, the IMF told us that inflation will only start to decline “once the pass-through of rupee depreciation is absorbed” into the price system, and temporary supply and demand pressures dissipate. This is a classic, textbook case of an overheating economy. And bringing this prairie fire under control is now priority number one for the government not gunning for more growth.
The writer is a business and economy journalist.
Published in Dawn, November 25th, 2021