Inflation and indexation

History asserts that inflation is a snake with a venomous bite; it cripples the vitality of an economy in many ways, both from macro and micro perspectives. The disease is not only for the developing and the Least Developed Countries [ LDCs] but equally valid for the developed world.

An oil crisis contributed to double-digit inflation in the 1970s in the USA with the onslaught of the Arab-Israeli War. The world is now observing runaway inflation; prices for gasoline and groceries are surging worldwide, tracing to the COVID pandemic and the inbuilt instability worldwide due Ukraine-Russia war.

Gerald Ford labeled inflation as “Public Enemy Number One.” Jimmy Carter called it the nation’s most pressing domestic problem, and despite the tough talk from the White House, prices kept climbing. Inflation expectation played a dominant role in the psychological bent of the mind. Fed Chairman Paul Volcker put the brakes on the economy by raising interest rates to over 10 percent during 1979--1981, and inflation retreated to just over 3 percent in 1987.

However, a trade-off between inflation and unemployment and the painful correction cost 4 million jobs in back-to-back recessions in the early 1980s. Inflation was not a severe problem in the USA for four decades until the pandemic struck, followed by the war in Ukraine.

However, the consumer price index calculated by the Labor Department is now over 5 percent. The Fed is on a spree to raise the interest rate that generates demand for USD with sizeable appreciation and a cut in consumption domestically.

The Fed is blamed for pouring cold water on the US economy in the hopes of dousing high inflation before “..it ignites a long-smoldering dumpster fire. The longer the current bout of high inflation continues, the greater the chance that higher inflation expectations will become entrenched. “ It is a lesson born of the country’s painful experience with runaway prices in the 1970s when Americans sported “Whip Inflation Now” buttons on their wide lapels.

Now we look into the inflation episode in Bangladesh in a historical anecdote. Inflation is currently over 9 percent in Bangladesh though inflation was not a severe problem during 1996-2001. The tenure of Finance Minister [1996-2001] Shah A.S.M.S Kibria was marked by economic progress and stability, the only exception being a stock market failure in 1996.

During his term, Bangladesh achieved, for the first time, GDP growth at an average rate of 6 percent. The average inflation rate was well below 5 percent, the safe level and the inflation rate in June 2001 was only 1.53 percent –an astounding figure to cherish. The national savings increased from 20 percent to 24 percent with pari passu increase in investment rate in 2000-2001. The growth could be triggered a few percentage points by inflation. Subsequently, Bangladesh navigated safely in macroeconomic management with a safe level of inflation till COVID-2019.

The Bangladesh economy is facing myriad problems after the COVID epidemic. There is pressure on the exchange rate, a continuous deficit in the current account, and a recent unusual deficit in the financial account that could make the overall balance of payments vulnerable. The exchange rate depreciated by over 20 percent, and the attack on the currency could be severe with the dwindling reserves below the safe margin. International prices may contribute 20 to 25 percent to the creeping inflation. Still, over 80 percent increase in the price of edible oil, sugar, onion, and many essentials could not be aligned with the trend of international prices-- a manifestation of the market syndication.

This is the final year of the government, and the surging inflationary trend hidden in the lens of the Consumer Price Index [CPI] could be a death blow. The CPI is constructed on the cost of a consumption basket for a specific group of people, and the trend is an essential determinant in judging real income. Moreover, the consumer price index compares the cost of a basket of commodities for a given year concerning another year, a representative year known as the base year. Thus the idea is synonymous with the cost of living, and statisticians often use it as the Index in measuring the cost of living.

Various commodities constitute the consumption basket of a typical consumer. When you look into the consumption basket of a mid-level wage earner, the main components are house rent, expenditures for food and clothing, and various bills for public utilities such as electricity, water, gas, transportation costs, cost of education, and other miscellaneous costs.

Each of the groups of commodities in the basket is assigned a weight based on the proportion of money a typical consumer spends. When the government raises the bill for water, gas, and electricity in phases, it will increase the cost of living. Considering the different weights for this basket, a price change for an item with a higher weight will raise the cost several folds. Indeed, when we scrutinize the cost of living, we observe that the rise in income or the wage rate lagged behind the expenditure on different heads. The recent price hike of daily necessities with inelastic demand, such as coarse rice, onion, and edible oil, may marginalize the daily wage earners. Working people near the poverty line, who spend over 45 percent of their income on food items, ultimately lose real income when the price of food items is increased.

The budget for FY 24 is a challenge for the governments on many counts; unabated inflation, sticking to the IMF’s criteria, and resource mobilization. Budget documents portray a mechanism for adjustment and accommodation. Ordinary people are forced to utilize past savings.

There is a demand for new pay scales for government officials, though this constitutes a minor percentage of the total working people. The government included a fixed salary increase rate on the basic pay to compensate for past income loss. Prime Minister is explicit on demand for a new pay scale; instead, she emphasized the incremental increase equivalent to inflation to compensate for the erosion of real income. The Western world addresses this issue through indexation. Indexation is closely related to inflation. Thus indexation restores the actual value of money due to inflation, either by law or contract. Therefore, if the inflation is 6 percent, an individual’s income needs to be augmented by 6 percent, which may help the individual maintain the same living level.

Many governments’ spending, especially the Social Security Benefits or retirement benefits in the United States, are directly indexed to Consumer Price Index. So overestimating or underestimating the Index may cost the government several billion dollars or reduce the real income of the employee. Understanding this simple statistical device may guide the officials to look for the employees’ welfare and maintain productivity in the public and private sectors.

The writer teaches at BRAC University and BIDS as an adjunct Faculty in the Master’s Program in Economics. He can be contacted at mirobaidurr7@gmail.com.