10 August 2014

Ethiopia: Why Governmental Declaration On Inflation Holds No Water


Strong structural and macroeconomic measures are necessary to avoid the looming risk of inflation, argues Abis Getachew, a macroeconomic researcher. No declaration would avoid the risk of inflation, without decisive measures, he reflects.

The recent price increase of consumable commodities is expected to raise the aggregate inflation, which was at the single digit level for the last 15 months. Though the government put the blame on business community, the recently observed inflation across the nation is consistent to the existing theories of inflation.

Milton Friedman's long lasting theory of inflation states that general price increase is highly determined by expectations. Robert Lucas, another economist, widened the concept that these expectations are not only formed by past information but also based on current information from media, press, reports and government announcements as well.

Therefore the recently observed inflation rates can be attributed to change in expectations. These changes are mainly driven by the mechanism in which the budget deficit for the year 2014/15 is planned to be regulated and by the government's announcement of wage increase for the civil servants. These two recent economic phenomenons led to changes in expectations of inflation among economic agents. Knowing how this occurred would help make better policies.

Before the legislature approved the 2014/15 budget, the media were stating that the budget deficit will be financed through the selling of the treasury bills and borrowings from the central bank. Though financing the deficit through Treasury Bills sales weakens and crowds out the private investment, it might not necessarily lead to inflationary pressures.

However, the announcement of borrowing from the central bank to finance the deficit will have an impact on inflation expectations and hence actual inflation. In a country where the central bank is loyal to the government, it is very difficult for the pubic to trust government announcements about money supply and borrowings.

Economic agents are also uncertain whether the government is borrowing the right amount from the bank. In such a situation, if the government itself makes it public that it will borrow from the central bank to finance its deficit, then, it is obvious that expectations about inflation will rise. This will then have a direct and immediate impact on prices too.

In addition, the shift in expectations is not uniform since the prices of similar items in the same markets here in Addis Abeba vary. From this, one can understand that expectations are formed more from personal judgment than the government announcements.

Moreover, one can clearly see that economic agents do not have confidence in these government announcements because if they are trusted then the price increase would have been uniform. If our country was blessed with strong labour unions and consumers cooperatives, they would have also faced the same problem in adjusting their wages and prices.

This is mainly due to a blurred view of the new money that will be injected into the economy. Because of such unclear information, economic agents could not set their share in the economy given the nations' total output.

To remove the high expectations of inflation that is associated with the budget deficit, the government should take measures to make the central bank independent. If the central bank is independent from the hands of the executive and accountable to the legislative, then the public will be increasingly confident that the incumbent government will not borrow money as it wishes.

Though it is difficult for a developing country, such as ours, to have a fully fledged independent central bank that targets inflation, at least it is possible for the government to offer partial independence for the bank by making it accountable to the legislative and providing it the freedom of choosing policy instruments.

On the other hand, the goal can be set with national consensus through negotiations between representatives of economic agents such as the business community, labour unions, consumer cooperatives, and the government and so on. In other words, an agreed upon level of inflation ought to be that which facilitates growth at its optimum level.

In such a case, the central bank will not only have a single goal of inflation but will also have a goal of economic expansion. Hence, once the goal is set, the central bank should be independent in choosing monetary policy instruments which is coherent to other policies in order to achieve the threshold level of inflation.

In addition, to strengthen the check and balance, the central bank should be accountable to the legislative body of the government. In such a way, inflation expectation due to budget deficit adjustment can be solved.

The second phenomenon that triggered the inflation expectation is the government's announcement of the nationwide wage increment for the civil servants. Though the government argues that the scale is not even announced to raise the inflation level, the announcement alone is adequate to trigger expectations.

An increase in the wage level should be appreciated. However, if the increment or the announcement is not associated with productivity and improved service provision, then it will lead to sever inflation and economic chaos.

In our everyday life, we witness the increasing corruption, mal-administration and the mix of governmental and party doings in the civil service, which partially show that productivity and service provision of the civil service is deteriorating through time. Thus, economic agents adjust their inflation expectations to higher levels, due to the belief that the new money is injected into the economy without improvement in productivity.

Though the initial intention of the government was to improve the living conditions of the civil servants, the impacts will be the opposite. Therefore, the bottlenecks of the civil service have to be resolved. Also it is necessary to create a productive environment in the civil service before the wage increment.

At least, such measures could create trust among the public that the salary increase is consistent with improved productivity. However, creating a productive environment and removing the bottlenecks of the smooth functioning of the civil service may take time. Thus, these policy measures could be taken as long term solutions. In the short-run, though, pro-urban poor measures can be taken to ease the cost of living, such as subsidising major consumption items, like kerosene and selected cereals .

In general, the expectation of inflation rates is the main reason for the recently observed inflation. To lower expectations of the public, the government is announcing every time that there is no economic ground for inflation to occur in the country. It further points fingers on a few greedy and irresponsible traders.

But traders are few in number compared to the total population of the country. A few traders cannot create nationwide inflation. Hence, the government should focus on making its announcements credible.

For government announcements to be credible, crucial measures, such as making the central bank at least partially independent and creating a conducive environment to promote productivity and remove the supply side problems, ought to be taken.

Africa's growth story could only be sustained if the continent manages to realise structural transformation, argues Arancha Gonzalez, former chief of staff at the World Trade Organisation (WTO) and now executive director of the Geneva-based International Trade Centre (ITC). In this commentary which initially appeared on The Globalist, she argues that marching towards smart industrialisation is the best option to realise structural transformation


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