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No Free Lunch: Understanding inflation
Posted: 6:51 PM | May 08, 2005
Cielito Habito
Inquirer News Service

THE LATEST word on inflation that came out last week hasn't been particularly encouraging; price increases show no signs of slowing down. For the third month in a row, the inflation rate has not abated at 8.5 percent, measured on a year-on-year basis, with the January rate only slightly lower at 8.4 percent. Since we are already into the second quarter and nearing completion of the first half of the year, the government's target of 5-6 percent average inflation for the year is now unlikely to be achieved; Ateneo's 7-8 percent forecast appears much more realistic.

What it means
Inflation is the sustained increase in the general price level. The inflation rate measures how fast overall prices are rising. Thus, an 8.5-percent annual inflation rate tells us that what you were able to buy for P100 last year would now cost you P108.50. As Neda chief in the 1990s, I would occasionally get peeved by columnists or radio commentators who would call me a liar whenever I announced a drop in the inflation rate. Their line would usually be, "How can Mr. Habito claim that inflation is down when prices keep going up?" But a lower inflation rate never meant prices are going down! It means that prices are in fact still going up, but more slowly (i.e. at a lower rate) than before. If prices were in fact going down, it would no longer be called inflation, but deflation. In this case, the inflation rate would not only be lower, it would be negative. A good situation to have, you might say--but economists and businessmen actually fear deflation just about as much as they do high rates of inflation. Japan, for one, had experienced episodes of deflation in recent years, and they were not all that happy about it. The problem with dropping prices is that it means there is not enough demand for the economy's given level of production, forcing producers to accept lower prices, and cut down on production, on jobs, and eventually on people's incomes and ability to buy their products. Left unchecked, it could turn into a downward spiral in the economy and a full-blown recession. So don't pray for negative inflation or deflation; pray, rather, that it simply stays close to zero. In fact, we don't want it to be zero either, as a little inflation is useful for stimulating increased production.

How it is measured
When Neda Secretary Neri or NSCB Secretary-General Virola (both of whom are named Romulo, coincidentally) reports an 8.5-percent inflation rate, they are describing an average rate of price increase. Prices of some products or services rise faster than others; some may in fact go down while others go up. The average itself is a weighted average, taken over a defined set of products and services --from 285 to 705 of them, depending on the province--considered to comprise the normal purchases (consumption basket) of an average Filipino household. Food products make up over half (55.1 percent) of the average household budget, with rice being the largest single item, accounting for about 11 percent, housing and repairs 14.7 percent, clothing 3.7 percent, and so on. The number widely quoted is the year-on-year inflation rate; that is, the announced April rate measures how prices rose from April 2004 to April 2005. One can also look at the month-on-month rate, i.e. the rate of increase from the previous month. This is actually a more informative measure as it tells us what the short-term trends are like. Because of this, other countries (including the US, Japan) prefer to report their inflation rates based on the annualized month-on-month rate, after correcting for seasonality.

Why it happens
Inflation can either come from a demand pull or a supply push. When the central bank puts too much money in circulation relative to production in the economy, too much money ends up chasing too few goods (i.e. too much demand), leading their prices to rise. That is why governments cannot simply print money indiscriminately, especially to pay their bills. When some irresponsible Latin American governments did so in the 1970s, they ended up with hyperinflation, at rates over 1000 percent. Housewives literally waited outside factory gates at payday to grab their husbands' wages and spend them right away, as prices would go up by the hour! Governments now know better; monetary authorities allow money supply to grow only to the extent that real production grows.

On the other hand, supply push inflation arises from rising production costs due to such factors as higher wage rates, rising energy prices, and a depreciating currency which raises the cost of imported inputs. This is the kind of inflation we are seeing lately, and unfortunately don't have as much control over.

Gainers and losers
Not everybody is hurt by inflation. In general, those who earn fixed wages and salaries--and that means half of the workers in our economy--get hurt by inflation because their wages rarely catch up with the rates of increase in prices. On the other hand, gainers include owners of businesses whose products go up in price faster than their costs rise. Lenders of money also lose while borrowers gain, particularly when the inflation rate exceeds the interest rate on the loan. This implies that the borrower actually pays back money with lower value than what was originally borrowed.

Part of the reason we borrowed so much from abroad in the 1970s was that it was arguably foolish not to do so. When the global banks were up to their ears with deposits of Opec's billions of petrodollars looking for a place to be invested, the banks were pushing cheap loans to poor countries at rates even below prevailing inflation rates. It was like they were paying countries to borrow their money! Little wonder that a lot of irresponsible loans were contracted, leading to massive defaults that had led to the Third World debt problem that plagues the world to this very day. Guess how much of it is ours?

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