Home ›› 28 May 2023 ›› Editorial
Inflation is now pervasive, and the worldwide trend is alarming; although, just before COVID-2019, many countries were in the grip of disinflation or deflation. The galloping inflation is fueled by inflation expectations, the presumption that intuitively measures how consumers believe will look in the future. For example, you want to buy a scooter one year from now. When inflation is within the safe level, say 5 percent, and corresponds to a positive real interest rate, i.e., the nominal interest rate is higher than the inflation rate; you are pretty sure that you can postpone the purchase because you are not expecting the price of cars to change very much in the next year. You are not experiencing erosion in your purchasing capacity as the value of money is protected by the positive real interest rate.
Now, consider a situation where you experience that the scooter price is rising rapidly. Your return from other investments or time deposits must trail the price hike, which could force you to buy a scooter instantly rather than wait for months while prices keep increasing. An economy-wide buying spree deciphers a solid message to manufacturers of scooters of the surging demand that follows a price increase. Higher prices would contribute to even higher inflationary sequels. This is the essence of inflation expectation; rising inflation makes people believe that prices will rise again, and when the prices of several commodities follow suit, the price level goes up and is reflected in the higher value of the Consumer Price Index [CPI] concerning the base year.
Inflation expectations matter because prices reflect, in part, what people expect them to be and design strategies to meet the income and expenditure gap. Thus the expectation reverberates in demand for a pay rise or the budgetary provisions in income augmentation and the enhanced benefit in the social safety net. The manufacturing sector is pressed with pressure for wage hikes to boost prices to accommodate higher wages that drive inflation. Consumer psychology is crucial in inflation expectations. The consumer looks to the central bank and the treasury department and observes the footprints of the twin policies considered instrumental in limiting the inflationary pressure.
The Fed employs several criteria in assessing inflation expectations. One vital instrument is the wage growth tracker. This helpful tool compares the present 3-month moving average of wage growth to the year prior. The 3-month average wage gain for all U.S. workers was +6.7 percent in August 2022 compared to +3.9 percent in August 2021 though workers are still falling behind. According to the Bureau of Labor Statistics, inflation-adjusted earnings fell 3% in July compared to the previous year. That tells us that the pay for average Americans is not keeping up with inflation. The Federal Reserve Bank of New York survey says inflation expectation would rise to 5.7 percent, down from 6.2 percent in July 2022, and expectations for where inflation would be in five years declined by 0.3 percentage points to 2 percent in August. Consumers and investors are more pessimistic about inflation today—perhaps driven partly by expensive gas prices—but they’re getting more optimistic about inflation over the longer term. Again, the 10-year breakeven inflation rate, a standard metric for longer-term inflation expectations among market participants, hovers around 2.4 percent. “Longer-term inflation expectations are typically more of a focal point for financial markets because shorter-term expectations tend to be more closely linked with gasoline prices. ”
The Fed responded to inflation by raising the federal fund’s target rate four times this year to 2.25 percent to 2.5 percent and is reducing its balance sheet and stopping buying long-term bonds. Higher interest rates and easing supply chain and production blockages as the world learns to live with Covid-19 may be why inflation expectations are moderating and soothing. If higher inflation persists for longer than expected, interest rate hikes fail to halt price gains, and supply chains remain tangled, then inflation expectations will rise.
Now consider the polar case of Japan in inflation expectation. Since the late 1980s and early 1990, the perennial deflationary syndrome caused sporadic recessions in several quarters with stunt growth. However, wage increases and the global energy and supply chain disruption contributed to rapid price hikes and increased inflation expectations in the aftermath of the Russia - Ukraine war. Surprisingly, the current inflation of over 4 percent amid supportive monetary and fiscal policy place the economy on a sustainable path of inflation above 2 percent. However, this warrants a cautious step in tailoring the interest rate amid the Fed’s surge of interest rate hikes. The central bank, the Bank of Japan [BOJ], with a negative interest rate, must be more proactive in accommodating the inflation spree with the yield curve in government bonds to meet the inflation target above 2 percent. This is feasible as the BOJ owns more than 80 percent of outstanding 10-year government bonds, and in-built flexibility in longer-term yields could pave the way for sustained inflation and reverse flow of investment in the domestic setting.
The inflation expectation in Bangladesh is “well anchored” according to a report the “Inflation Outlook for Bangladesh” prepared in June 2022. Domestic inflation is expected to peak in the short term (3rd quarter of 2022) and decrease later towards the end of 2023 with the projected easing of global commodity prices. Bangladesh set an inflation target of 5.6 percent for FY23. Still, it is impossible to gauge at what level the inflation rate will reach this fiscal year because global commodity prices, including fuel and food, remain above the pre-war levels alongside the currency’s depreciation by 25 percent.
In contrast, increasing subsidies will keep inflation at around 7 percent. Similarly, if the burden of rising gas and oil prices are passed on to consumers, food inflation will go up to 9.4 percent in July-September. With no hike in the prices of gas, electricity, and oil, the inflation rate will stand at 6.7 percent. Uncertainties are embedded in these projections, the continuity of the Russia - Ukraine war, and the political climate before the general election in the next year.
“Striking a delicate balance between containing inflation and supporting recovery requires a mix of appropriate fiscal and monetary policy. Allowing for the pass-through of global commodity prices with targeted support for the most remains the first best policy option.” The policy paradigm of Japan and the USA could be the better guide for any country to follow.
The writer teaches at BRAC University and BIDS as an adjunct Faculty in the Master’s Programme in Economics. He can be contacted at [email protected].
