111 510 510 libonline@riphah.edu.pk Contact

Inflation only a supply-side phenomenon: a quarter-truth

During inflationary times, the notion propagated by the gurus that inflation is solely cost-push/supply-side phenomenon in Pakistan, is taken as the gospel truth by many, including the fourth pillar of the government, namely media. Lately this widespread belief has taken an ideological tone similar to the two other prevailing long-running debates: a) whether military or civilian rule has led to higher economic growth and at what cost?, b) whether the IMF programmes made ‘structural’ differences in the working (for better or for worse) of the economy? The following three dimensions of the inflation debate will be highlighted to suggest that the current popular narrative on attributing inflation to only cost-push/supply-side factors is half rather than the whole truth.

The ideological tilt in favour of supply-side inflation by the ‘home-grown’ strategists stems from the opposition to any stabilization measures based on the monetarist view of the inflation. In economic discussions based on imbedded ideologies or partisan approach to evidence, any claims by the gurus override counter evidential arguments and since it comes from gurus, it becomes the whole and the ‘only’ truth. It is an accepted fact that for any economy going into ‘coma’ (for the time being lets ignore that how it landed into that condition in the first place and whether it made any sense to approach the doctor) the first resort of the doctor is to prevent it from going into that state no matter how painful it is and later address the ‘structural’ issues. Unfortunately, in the last 30 years the structural reforms have taken a back seat, few that can be counted on finger tips were implemented at a snail’s pace defying and diluting the time lines essential for sustainable recovery to fight the next round of illness. Geo-political, geo-strategic trump cards, mafias, bureaucratic lethargies and rigid mindset, ideologies and political/provincial divisiveness eroded whatever little political and academic support existed for deep-rooted reforms. The above inter-temporal landscape of the economy and the state has been used to wriggle out of the hard core structural policy matrix attached to each lending document. Let me be provocative and mention that it took India just one IMF programme in 1992 to commit to just opening up the economy (not capital account) for sustainable growth. The rich endowment of human capital (service sector) and scale economies did the rest without strictly following any timelines on structural reforms. Pakistan wasn’t that lucky and used these programmes and continues to do so for increasing indebtedness, inflating consumption and economic survival.

As high frequency data is sparse, its availability lags are lengthy as well it is less detailed in developing countries, the discussions on the causes of on-going high inflation are mostly casual empiricism, rather than from the hard evidence of ongoing phenomenon. Moreover, with numerous inflation indicators in vogue, cost-push/supply-side explanations cannot be equally applicable to all of them. Attributing high inflation only to supply-side factors is akin to putting demand-side pressures under the carpet for more than 400 items constituting the CPI. The basket of food inflation has far less items, but in absence of data on monthly food balance sheet for each of the perishable and non-perishables in terms of carry-over stocks, production, imports, exports, wastage and timelines of inter-provincial seasonal supply chains, attributing food inflation to lower supplies is telling the half-truth. Not recognizing that deprecation of the currency along with increase in international prices invokes the ‘Law of one price” in terms of smuggling and hoarding. It outweighs any shortfall in physical production and disruption in inter-provincial supply chain. In case of wheat it forces the government to raise the support price in order to reduce smuggling and goad the hoarders to voluntarily bring the stocks into the market. The food inflationary episode continuing since 2020 is also the result of trade closure with India on which we continued to rely to meet seasonal shortfalls in production (e.g., onion, potato, tomato) simply because inter-temporal demand exceeded relative supply.

Nearly most of the empirical studies related to Pakistan on inflation, conclude that cost push/supply-side factors to inflation is only half-truth or one side of the coin. Thus ignoring demand pull factors implies an ideological bias. Of course the relative magnitude of contribution of either of the two sides of the coin depends on the specification of the empirical model, time period of the data and estimation techniques used. Two studies are used to demonstrate the whole truth in this debate.

The first one is slightly dated and was published in SBP-Research Bulletin (2006). Monthly data from January 1998 –June 2005 was used that included 2 episodes of increase in wheat support prices and 1 episode of rising inflation from 2003 to 2005. The empirical results presented in this paper show that monetary factors determine inflation in Pakistan. Broad money (M2) growth and private sector credit growth are the key variables that explain inflation developments with a lag of around 12 months. A long-run relationship exists between the CPI and private sector credit. The wheat support price affects inflation in the short run, but not in the long run. The wheat support price matters for inflation over the medium-term only if accommodated by monetary policy.

A more recent study in Journal of Emerging Issues in Economics, Finance and Banking (2014), is also based on monthly data from July 2006-Feb 2014. The model specification uses a greater number and more relevant supply-side variables than the above research, but is less rigorous in statistical analysis and yields less robust results compared to the above paper. Apart from the usual monetarist indicators, namely money supply and private credit, it incorporates exchange rate, industrial input price index and price of crude oil as supply-side/cost push variables. From a long-term relationship, in terms of elasticities (impact), the three highest are money supply, private credit and exchange rate. Industrial input price index, crude oil price and interest rate also impact from the supply-side but have relatively low impact on CPI. This study concludes that inflation in Pakistan is not only demand-pull but cost-push and structural in nature. Not the half-truth as popular in media but the full-truth.

In the end, argument is briefly presented on changes (specifically depreciation) in exchange rate and its transmission to inflation. The primary reason for depreciation of the rupee is rate of growth of imports exceeding rate of growth of exports. Population growth, undocumented incomes (including agriculture), wealth creation based on subsidies, tax expenditure, amnesty schemes (also increase deficits and money supply), weak fiscal stabilisers in a growing economy, negative real rate of interest and casino investment (currently it is in auto, real estate, imported consumer goods) behaviour are all demand-side triggers for the exchange rate changes. The effect is transmitted as cost-push inflation as a secondary impact via changes in administrative prices including energy, to stabilise the fiscal deficit. Thus the origins pre-dominantly, always lie in demand-side relative to supply-side triggers. Thus propagating that inflation is only a supply-side phenomenon is a quarter-truth not even the half-truth.

Dr Sajjad Akhtar, "Inflation only a supply-side phenomenon: a quarter-truth," Business Recorder. 2021-05-14.
Keywords: Political science , Federal government , Budget allocations , Fiscal responsibility , National Assembly , Monetary policy , Economic Corridor , Pakistan , Finance , IMF , CPI , SBP

Leave a Reply

Your email address will not be published. Required fields are marked *