We have been taught that inflation is primarily a result of either rising costs (cost-push inflation) or increases in demand/consumption (demand-pull inflation). Whichever type it is, inflation is the rate at which the prices of goods and services rise over a specific period of time causing a reduction in purchasing power. This means that when inflation is rising, consumers’ income is diminishing in value and vice-versa, however, a small percentage of inflation is healthy to have in any economy since this is indicative of a growing economy.
Over the recent years, central bankers have had to deal with demand-pull inflation through monetary policy. As an example, you would have an economy which is growing as a result of its efficiency and competitiveness, attracting investment, which in turn creates job opportunities. The increase in income generation causes an increase in consumption which causes prices of goods and services to increase as a result of the demand pressure.
Central bankers would increase interest rates gradually in order to try to control inflation and keep it close to a predetermined desired level. This is achieved due to the fact that higher interest rates would increase the cost of capital for the entrepreneur and increase the cost of borrowing for the consumer thereby decreasing the demand for goods and services. This cycle will keep repeating each time inflation moves away from the target rate of inflation which an economy deems ideal for itself.
Today, Europe has to deal with cost-push inflation which is primarily a result of surging commodity prices – from oil, to cotton, to grains, to gold. These higher costs create challenges for companies in industries like food retailing and appliances, as they try to pass on price increases without alienating the consumer. The ramp up in commodity prices reflects both the broad global economic developments as well as conditions very specific to certain industries. The conflict in Libya hot on the heels of unrest elsewhere in the Middle East has disrupted oil prices. Bad weather in China and Pakistan has resulted in diminished cotton output from these regions, while weather instability in Russia and Canada has hurt wheat crops – cotton prices alone are up threefold over the recent past.
As consumers watch their bills rise for a variety of products and services, the question -becomes what this trend means for the inflation rate. The Federal Reserve is of the view that commodity costs are a relatively small percentage of overall costs for consumer goods and hence the upward pressure on prices right now is modest. On the other hand, the ECB raised rates by 0.25 per cent recently as its inflationary concerns increase. One may ask what the economic (and political) implications of this (and other possible future) rate hike will be given the current fiscal and economic backdrop of a majority of European Union member countries?
In last week’s article we quoted the concern of the Governor of the Central Bank of Malta, Michael Bonello, on rate hikes within Europe and how these will affect debt-strapped European nations. I am still confused, but not that surprised, with the ECB’s interest rate hike. Confused because I believe the majority of European Union members are still not yet ready to deal with the economic effects of an interest rate hike. Unemployment is still high and savings are pretty stagnant – these economic indicators need to be considered and analysed in order to determine the strength or otherwise of a nation. I am not surprised because the ECB’s primary role is to safeguard price stability rather than to ensure economic growth.
We could be facing a new generation of inflation which is not solely controlled by monetary policy but which is addressed via increases in output through the more efficient use of resources. This will compensate for part or all of the cost increases in raw materials and hence bring down the overall cost per unit of goods and services.
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Mr Micallef is an investment executive at Curmi and Partners Ltd.