Economic Policy Review ISSN 1313 - 0544

Did We Wrestle with the Inflation?

Author: Adriana Mladenova / 28.05.2009
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"The most important thing to remember is that inflation is not an act of God; inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy..." 

Ludwig von Mises

Economic policy, page 72

This week the National Statistics Institute (NSI) reported the inflation for March, which is -0.2% (measured by the index of consumer prices), i.e. during March there is a deflation in the country. From the beginning of the year the compound inflation is 0.65%, while the average yearly inflation, on an annual base, fell to 6%. Only 5-6 months ago such data would have looked as science fiction. During May and June last year the annual inflation was over 15% and the price increases in the country were on the agenda of the public space and the main concern of the people, as well as for the external analysts. Which is logical since, the high inflation means reduced purchasing power of the population (under equal other conditions).

This which began to happen from the beginning of the year - namely, reduction of the prices and even deflation during the third month of 2009 is a manifestation of the crisis. The demand is declining, crediting is reduced and from there the prices for goods and services.  Because the market prices (those which are determined by the market not by administrative means) react to the market conditions and the changes in supply and demand. This is not the case with the prices of goods and services which are administratively determined and which are managed or regulated to some extend by the state. These prices usually do not measure the supply and demand and are politically founded and often could not be forecasted for a foreseeable period of time. Exactly the existence of a large percentage directly or indirectly regulated prices of goods and services in a given economy leads to more unfavorable business conditions and as a result fewer investments.

In economics there is the following relation - increasing the money supply in the economy leads to increase in the overall price level in the economy. The logical question then is why in these conditions of financial crisis and respectively - various anti-crisis packages and measures of the governments around the World, related to increasing the liquidity of the markets (either by reducing the interest rates by the central banks, printing money, spending money from the budget for public projects, bailing out of private companies, at cetera) the price levels in the countries do not increase and even in some economies deflation is observed. The reasons are as follows:

  • As Milton Freedman notes in the 60's of the twentieth century, there is a time lag between the increased money supply and the increase in the price levels of the goods and services. However, in the long run there is a clear positive correlation between the nominal quantity of money in the economy and the price level. 
  • Although the money aggregate M1 (money in circulation and the overnight deposits by the banks) is increasing sharply in the Euro-zone, the rate of increase of money aggregate M3 (which includes also deposits and liquid instruments) is slowing down (from 11.2% during the first quarter of 2008 to 5.9% in the beginning of 2009). After a while, when the financial institutions begin to function normally (to give more credits), M3 would also increase sharply (due to the money multiplier). Which would lead to inflationary pressure?!

In the long run the money policy of the European Central Bank (ECB) would affect the Euro-zone and Bulgaria and it would be in the direction of increased prices. We should not forget that just the money policy of ECB and the Fed on maintaining low interest rates in the economies is one of the root causes for the current global economic crisis. That does not mean that in the short run the monetary policy of the ECB has no effect on the real economy, quite the opposite. Each policy changes the relative prices in the economy (the relation between the prices of various goods and services) and thus directs the money players to specific sectors. Through the interventions, the government has an effect on the behavior of the financial institutions and on the behavior of the investors.

Here are the comments of Ben Bernanke head of the US Federal reserve with the Financial Times on Tuesday (14th of April): „Although inflation seems set to be low for a while, the time will come when the economy has begun to strengthen, financial markets are healing, and the demand for goods and services, which is currently very weak, begins to increase again. At that point, the liquidity that the Fed has put into the system could begin to pose an inflationary threat unless the FOMC acts to remove some of that liquidity and raise the federal funds rate."

At the same time we should keep an eye on the policies of ECB and the actions, which it undertakes, because Bulgaria "imports" monetary policy from the European Union under the conditions of a currency board. There are expectations that the ECB would reduce the basic interest rate with further 2.5 base points next month. Axel Weber, member of the board of the ECB, is against the policy of ECB for continuous reduction of the base interest rate on the inter-bank market. He stated the following with the Bloomberg information agency: "I'm critical of reducing the main refinancing rate below 1 percent, because there would be practically no incentive for banks to lend to each other... Therefore, the risk exists that the private interbank market would become completely paralyzed."