Fighting inflation

"A nickel ain't worth a dime anymore"- Yogi Berra. For those slow on the uptake, substitute Rs 100 for a nickel and Rs 10 for a dime. Inflation is mysterious. Even those who claim to understand inflation have a tendency to overlook inflations mischief in their real life. Explaining that money, itself an illusion, has a cost is as impossible as replacing a hatched chicken in its shell, The dilemma in trying to explain inflation, more than in any other case, is the beginning.
Inflation is the rate at which the general level of prices for goods and services is rising, and consequently, purchasing power is falling. Accordingly if Rs 100 buys 5 apples today, at 20% annual inflation, next year it will only buy 4. So unless income rises by 20% as well, the household will mandatorily have to consume less. And if earnings increase continues to trail inflation for a number of years, the eventual outcome will be fatally punishing for the quality of life. Sound familiar?
Perhaps, inflations impact on stored wealth is more severe. If the rate of inflation is more than the appreciation in value of investment, there is net erosion in wealth, synonymous with killing previous profits. Exemplifying simplistically, if all wealth is in a bank deposit returning 10% annually and annual inflation is 20%, the household is on a fast track collision course with starvation. Fundamentally therefore, battling inflation for the betterment of the populace should be any government's foremost agenda.
Typically, it is believed that there is an inverse relationship between inflation and interest rates. This suggests that the State Bank of Pakistan's decision to slash the discount rate by 150 basis points is because inflation is too low; lowering interest rates begets higher inflation. Ab initio, the preceding sentence makes no sense; back-breaking inflation has already crippled the nation, why do we need more? Professedly the decision was taken to spur economic growth by cheapening credit, increased inflation is just the by-product.
However, this strategy facilitates borrowing to the detriment of the very depositors who provide capital. Negative real return cannot incite savings in bank deposits, suggesting that funds will move to more lucrative options for saving wealth, like gold and real estate.
Real return is the rate of interest an investor expects to receive after allowing for inflation. Meaning that if official inflation rate averaged 10.6% over the last 10 years and weighted average deposit rate hovers around 8%, depositors are better off spending their money now rather than saving it, which means more inflation. Perilously, this explanation assumes that the official rates closely mirrors actual inflation. Contrarily, if actual inflation is steeper, there never was any point in saving in the first place.
Universally estimating true inflation is a Pandora's Box let alone in Pakistan where the accuracy and authenticity of underlying data remains subject to criticism.
The decision as to what should be included in the CPI basket can significantly cloud results. Additionally, perceptions of inflation by middle and poor classes have nothing to do with average inflation. Averages are terrible for decision-making purposes. If the lower middle class pegs inflation with the price of fruit, the CPI index will remain irrelevant for them.
Forget inflation, in a country where there continues to be a debate on the size of the undocumented economy, assuming a correlation between interest rates and economic growth is slightly optimistic. Even the supposed best of the best in western economies, where data is more or less reliable, got it wrong when tampering with interest rates. Low inflation rate allowing for low interest rates resulted in the sub-prime and Euro debt crisis.
By now it must be abundantly crystal clear that fiddling with interest rates to curtail inflation requires genius level wizardry with zero margin of error. This is before factoring in currency exchange rates and globalisation into the equation and without even discussing the risks associated with hyperinflation, deflation and stagflation.
"The economy depends about as much on economists as the weather does on weather forecasters"- Jean-Paul Kauffmann.
Irrespective that controlling inflation is not an absolute science, gambling on inflation, Enemy no.1, for economic growth seems puzzling. The apparent reason is that inflation has the tendency to confuse real economic growth. While inflation might not increase productivity, it does increase the profit numbers and very rarely do stakeholders realise that in essence they are no better off. Since the vagaries of inflation are deceptive, higher profits confuse discernment. From the government's perspective, inflation increases taxation collection thereby confusing the real deficit, a highly favourable outcome.
"By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens"- John Maynard Keynes.
To fight inflation there is a need to understand inflation. The basic concept is perhaps explained by the popular widget example. If an economy produces 5 widgets and has a money supply of Rs 100 each costs Rs 20. If production remains constant and money supply increases to Rs 200 the price doubles to Rs 40, a 100% inflation; the classic quantity theory of money. More money chasing the same goods will increase prices, which in turn will result in increased wages requiring more money, a never-ending cycle.
Again the money supply falls under the purview of the central bank. Printing money or creating money through money market operations are magical qualities, and as with magic in general, need careful application. What exactly is the optimum quantity of money in an economy is possibly a bigger riddle than interest rates and is best left to a later write up. Plausibly, double digit inflation does suggest that Pakistan has more money than needed.
The logical solution, for fighting inflation, than is higher interest rates and less money chasing goods. Admittedly while managing both in tandem requires genius level intelligence with the outcome remaining uncertain, unabated obtuseness on the part of the government is bewildering. Everybody loves price stability which simultaneously generates positive signals for the future. Ever increasing wages and prices sustained by a continuingly increasing money supply is an unsustainable mirage. At some point the house of card painfully collapses. So why don't governments vigorously fight inflation.
As stated earlier, the delusion of economic growth fostered by inflation is enticing for short-term political gains. On the other hand, controlling inflation can take more than 5 years and in the interim period warrants a high level of commitment due to associated suffering. The wrath of the electorate has a sobering adverse affect in the fight against inflation.
Price hikes are depressive and known to have toppled governments; but which government? Inflation has a cumulative affect, the government holding the pillow when the music stops, losses. Unfortunately, governments will come and governments will go, and unless concrete steps are taken, inflation, or worse, hyperinflation will become a part of life.
Conceivably, media led opinion building to label fight against inflation as the key agenda for the next election might be a solution. In the meanwhile, go out and spend while the money lasts!