Inflation: What’s bad and worse about it, and how to prevent the ugly?

Mussie Delelegn Arega (PhD)¹

Part 2

Controversies surrounding inflation

The concept of inflation or inflationary gap is as old as the study of economics. It is one of the subject matters where governments and academics and financial institutions collate and compile data regularly and systematically. Likewise, there is overwhelming historical and empirical evidence on the bad, worse and the ugly face of inflation. Causes and consequences of inflation are also among the exhaustively researched, most debated, and widely published subject matters in economics, development economics, finance, political economy, and business decision-making processes. As it is directly linked to a business cycle or industrial fluctuation, the phenomenon of inflation is one of the carefully watched and seriously followed matters both in the theory and practice of business cycle as well as entrepreneurship.

As in the past, currently, debates on inflation are raging once again across nations, political establishments, economists, central bankers, monetary and fiscal policy experts (and practitioners). As they are within trade, finance, or development-oriented regional and global institutions. At the national level, the US Senate adopted the Inflation Reduction Act 2023. Political establishments and parties in many other countries-developed or developing-have also been extensively debating as to what to do to curb inflationary pressure on economies and societies (often along political lines of arguments). Some countries are using export controls or bans on domestically consumed foodstuffs to minimize the negative impact of price increases on their citizens and on the purchasing power of local currencies. The July 2023 meeting of ministers of finance and central bank governors of the G-20 held in Gandhinagar, Gujarat (India), was devoted to, among other things, how to best address inflationary pressure and fragmented global demand and supply challenges while maintaining stable microeconomic and macroeconomic policy environments. The extent and the frequency of debates show the seriousness of the matter and the determination of policymakers to get rid of inflationary pressure in their economies. This is because high inflation puts economies and societies at serious risks, and heightened uncertainties, with the poor and the vulnerable bearing the brunt of its adverse consequences.

Despite all the efforts and growing consensus on its adverse socioeconomic consequences, inflation remains conceptually messy and analytically controversial. There is no common understanding about its causes, transmission mechanisms, socioeconomic impact, what it does to the economy or how to contain it. Researchers and policy experts often clash on the causes and consequences of inflation, as well as its precise transmission mechanisms. Debates are inconclusive and reaching agreements on how high prices should be allowed to rise and how long they should keep increasing remains elusive. Moreover, there is no conclusive evidence on the causal relationship between inflation and economic growth, although higher inflation is believed to be anemic to economic growth. Nor is there a common understanding of what level of inflation is good and what level is bad for the economy and societies. Questions as to why inflation is inconsistent or variable over time particularly at double-digit level is still the subject of debates and controversy. Worst of all, inflation is the most confusing, unfathomable, and conceptually difficult subject for political elites to fully grasp its causes, consequences, and potential remedies. Yet, political elites both in developed and developing nations attempt to use and misuse inflation to advance their political interests often by inflating their economic scorecards.

How is inflation measured?

Measuring inflation involves complex statistical, mathematical, and econometric algorithms. It also involves the combination of skills of economists, data scientists, statisticians, and the latest software or more recently, programming specialists. In developed economies, multiple indices such as the producer price index (PPI), the urban consumer price index (U-CPI), the wage-earners consumer price index (W-CPI), the personal consumption expenditure index (PCEI) and the Gross Domestic Product Index (GDPI) are used to measure inflation. However, most developing countries use regionally disaggregated national consumer price index (CPI). In several other countries, urban or cities focused consumer price index is used to measure average changes in prices of consumer items between two reference time periods. Since most countries of SSA use CPIs, the focus here will be confined to this index.

CPIs have long been in use (since the 1870s), although the indices have significantly changed or evolved over time both in the methodological rigor of measurement, the objectives, and purposes for which the index is used, and the extent of goods and services measured by the index. CPIs use data from household surveys and provide an estimate of the price changes for consumer items used by most households such as food, clothing, shelter (rentals), medical services and supplies, etc. which yield weighted average of prices by using arithmetic or geometric mean. Therefore, CPIs measure price changes in the consumption sector of the economy and they do not measure investments or production aspects. For instance, such indices exclude investments in stocks, bonds, real estate, and business-oriented services.

In terms of methodology, CPIs go through different computational iterations and statistical processes, ranging from sampling surveys, data collection (and organization), normalization, weighting, standardization, and aggregation, among others. It is important to emphasize that CPIs are not a perfect measure of price movements, but they are the best available tools to gauge the trends in consumer prices for use in public and monetary policy making processes. However, the CPIs are not costs-of-living indices. Nor do they measure relative living costs, as they do not show price changes in two different geographical locations or cities within the same country during measurement periods. Moreover, CPIs only show goods and services that are in the survey samples that are consumed or used for day-to-day living, leaving prices of many other consumer items excluded or unmeasured. The CPIs also suffer from sampling errors and their accuracy largely depends on the verity and honesty of responses given by consumers or households. Besides measuring price movements, CPIs are used for different purposes particularly in developed economies. These include indexation of wages, pension income, and social security with respect to consumer price movements. It is also used for indexing interest rates from investments, rental payments and to deflate household consumption expenditures, national accounts or purchasing power parities.

As discussed earlier in the article, in sub–Saharan Africa, an important contributor to consumer price rises in recent years is food inflation, given that the region historically faces shortages of production due to several factors. These include weak economy-wide productive capacities and the low productivity of agriculture, poor land policies that limit access to women and other vulnerable sections of society, climate change impacts and the combination of other supply-and demand-side constraints. Rising cost of energy (electricity) and fuel in several countries of SSA also contributes to the rise in consumer price indices, undermining agricultural and manufacturing value added to GDP and making transportation unaffordable particularly to the poor. For many countries of SSA, agriculture is the dominant sector in terms of employment generation, ensuring food security, generating export earnings and in its share in GDP. However, the value of addition from agriculture has been precipitously declining over the last several decades. For instance, in Zambia, more than 66 percent of the population earns its livelihood from agriculture, but the GDP share of agriculture remains low at around 3 percent.