Illuminating inflation landscape

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Clive Mphambela
Recent developments in the Zimbabwean economy have prompted many economists to wade into the debate on inflation. Some healthy exchanges have occurred in recent weeks, with many diverse views and opinions being shared, by economists of different schools of thought and persuasions and indeed circumstances.

The subject of inflation itself however, has traditionally being an area of substantial controversy as economists rarely agree on many fronts.

The experiences of the last three or four months and in particular, the rapid rise of the stock exchange( and rapid correction in the last few days), the surge in prices of mainstream basic consumer goods linked to developments on the foreign exchange markets, have ignited significant discourse on the inflation landscape in Zimbabwe.

Whilst there is consensus on the general direction that inflation will take in the short to medium term. We have had a whole range of opinions, from near alarmist and extremely pessimistic views to very conservative ones.

My discussion this week I hope not to add to the confusion, but share perspectives that hopefully help to illuminate our economic landscape and hopefully help businesses and others out there make better judgments about the emerging trends.

As already alluded to there is already consensus amongst economic analysts that inflation in Zimbabwe is trending upwards.

Differences in opinion however revolve around, how fast inflation will rise and how far or how high it will go. In order to even begin to pose possible answers, we need first to lay out a common understanding of the key drivers of inflation in our economy.

A debate we cannot possibly exhaust in one discussion. Nonetheless, some economists are already seeing the tell tale signs of the hyper inflation that decimated savings and crushed the Zimbabwe dollar between 2000 and 2008. To what extent are these fears justified?
The CPI figures released by Zimstat last week unquestionably indicate, resurgence in inflation, which many economists attribute mainly to dynamics on the foreign exchange markets.

However, my considered view is that on closer inspection, the inflation trend reflects, rather the embedded structural weaknesses in the economy, and the CPI is not just tracking the recent imbalances in the money markets, but the effects of the dislocations that have happened between the external sector and the domestic money supply.
This relationship works via the current account and the financial account in balance of payments lingo. The key lies however in understanding what phenomena are really driving  inflation now, which was absent in the last few years? Or was it?

Without doing any rigorous econometric modeling, it has been obvious just by cursory inspection or observation that:-
1. Government borrowings have been increasing at an increasing rate.
2. This has had an impact on money supply growth.
3. Resulting in the noticeable rise in demand for foreign exchange against static growth in supply.
4. Leading to a rise in the price of foreign exchange and hence impacting domestic price dynamics.

Whilst there are many arguments by economists about the real nature of the relationship, there has always been an acceptance that there is a strong correlation or causality between money supply stock, the rate of money supply growth and inflation.

The basic monetarist explanation of inflation is through the traditional Quantity Theory of Money, MV=PQ where M is the Money Supply, V is Velocity of Circulation, P is Price level and Q is the total sum of Transactions in the economy or total Output.

Based on the Monetarists argument that Velocity and Output are determined, in the long run, by real variables, such as the productive capacity of the economy, monetarist school economists then postulate a direct relationship between the money supply growth and inflation.

This relationship is structural.
It is critical to understand that the money supply has basically two key contributors or sources, net current account inflows and domestic credit expansion.

The mechanisms through which excessive money supply growth may translate into inflation are summarized as follows.

First individuals will seek to spend their excess money balances on goods and services, triggering inflation by raising aggregate demand.

Aggregate demand in the economy has been high, and a large portion of that demand has been met by imports. There is an avenue where increase in demand can result in an increase in the demand for labour resulting from the higher demands for goods and services this would normally trigger a rise in unit labour costs and therefore money wages.

However, given that local productivity is low and unemployment is high, there has been modest growth in these labour variables. It leaves that the increase in demand for goods and services has been absorbed largely by the rising or high level of imports.

Whilst money supply leakages from the domestic economy via imports counterbalanced the rapid expansion of money supply for the greater part of the dollarised period, resulting in the low or negative inflation that we were experiencing, there was a net increase money supply, which increased the demand on the foreign exchange market thus applying downward pressure on the exchange rate.

This is is what is causing the recent spike in inflation. It is basically what we would call “imported inflation”.

Thus inflation in Zimbabwe is merely a manifestation of the structural weakness of the Zimbabwean economic model, which was always bound to run into problems because of its unsustainable nature.

The economy has been sustained by borrowed money and borrowed time. The chickens have simply come home to roost.

This view is in direct contrast to the view that inflation is being driven by increased business activity (2018 Pre Budget Strategy Paper) which states: “The pressures on prices are also against the background of higher business activity across the economy’s various sectors, particularly in agriculture, agro-related value chains, as well as mining.”

It is also very plausible to argue that during in the deflation years, there was some manifestation of money illusion, or price illusion in the economy.

Money illusion refers to the tendency of people to think of currency in nominal, rather than real, terms. In other words, the nominal value or face of money (currency) is mistaken for its purchasing power (ie real value).

In this context, whilst it was apparent that a US dollar in Zimbabwe was worth more outside Zimbabwe and could buy more goods and services, basically because things were more expensive here, most of us simplistically assumed that a US dollar in our pockets in Zimbabwe was the same value as a dollar outside.

We completely did not take into account the existence of a real exchange rate, which dampened the competitiveness of locally manufactured goods on the export markets, whilst making imports cheaper. It makes sense therefore that the economy became an attractive source of US dollars, because of higher local prices and hence lower relative value of local dollars, explaining why it was profitable to come and dump products in Zimbabwe and export dollars.

What are the possible policy implications of the above analysis?
Firstly, we conclude that the recent surges in inflation are being driven by the growth of fiat money in the system, largely influenced by that component of domestic money creation unrelated to external inflows.

In other words, it is the money that has been created by the expansion of domestic credit to Government and the private sector, to the extent that such credit has been translated into import demand that has been the sole driver of inflation.

The contribution to the money supply due to foreign inflows via the current account, has in my view, been inflation neutral

It follows therefore that the introduction of bond notes was just the trigger and perhaps also an accelerant, but the ground was already fertile for rapid price rises to begin to affect the economy in the manner we have experienced since the beginning of the year.

This is because foreign exchange shortages where already being felt in the market, even before bond notes were introduced. There was already a separation of the different utility values of paper money and electronic money in the minds of economic agents, a phenomenon known in behavioural economics as mental accounting. One would find therefore that it is completely reasonable to postulate that

If left unchecked, Inflation may well pick up from around 3% currently to between 50% or 60% in the next six months. This poses numerous risks to the economy.

One sector likely to suffer most affecting all classes of businesses is the labour market. Most of us in business use the CPI proxy as an indicator of both the current level and anticipated direction of inflation.

Unfortunately, evidence is abound that suggests that inflation as measured by the traditional CPI, is not a reliable guide to actual changes business costs, or even household expenditures.

For businesses, the major risk is that we may see nominal wages rising significantly faster than productivity, due to the fact that 2018 is an election year and generally labour voices will be very strong.

This is particularly likely because wages have been suppressed for a long time on the back of the “deflationary” conditions we have been experiencing over the last few years. Collective bargaining contracts were indexed to the CPI, a wrong proxy, giving a basis for this outcome. However, whilst real wages were fixed or falling, household incomes were under pressure from real changes in the costs of running a basic budget.

The average consumer has faced a rapidly increasing cost of the monthly basket of goods, totally unrelated to the levels proxied by the CPI. These factors will make wage negotiations tough, but the environment will tilt in favour of the workers.

Another aspect that stands out, is that we need to take bold measure to make imports into Zimbabwe dearer and our exports relatively cheaper in export markets by removing structural factors that have been undermining competitiveness in the economy since 2009.
The question is how do we do so in a country that currently relies mostly on imported shelf goods and intermediate goods?

The writer is an economist and the views expressed in this article are his personal opinion and should in no way present views of any organizations that the writer is associated with.

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