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Published On  Oct 30,  2011
   
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Despite the fact that the Ethiopian economy continues to register robust economic growth amid a global recession, inflation is eating the earnings away, underpinned with structural flaws, observes Eyob Tesfaye (PhD) - etsfaye48@yahoo.com - a macroeconomic analyst and former head of the Public Financial Institutions Supervising Agency (PFISA). Taming inflation requires redressing the structural flaws albeit consistently, he recommends.       

Single Digit Inflation Undesirable during Economic Takeoff

 

Whilst the US economy teeters on the brink of a recession and many European economies are besieged by colossal public debt, several emerging and a few developing economies continue to enjoy robust growth.

Similar to other rapidly growing economies, the Ethiopian economy carries on to register vigorous Gross Domestic Product (GDP) growth. Although the growth performance remains exhilarating, the country’s economy remains in the grip of double digit inflation, currently standing at 40.1pc. 

Apparently, the runaway inflation, together with the high inflation expectation, has become a serious predicament to the administration. Indeed, in early 2011, the country was able to achieve single digit inflation, leading everyone to believe that this nemesis was overcome. 

Nevertheless, the inflation has once again resurfaced with a vengeance. The whole situation is reminiscent of a family that expressed gratitude for the survival of their home from a powerful hurricane but failed to prepare for more storms to come.

Inflation is an inevitable byproduct of economic growth, just like the increased exhaust emitted from a speedy car as it accelerates. As economies grow faster, it is inevitable for their engines to overheat. 

The Ethiopian government has taken several policy and administrative measures to cool down the economy and keep a lid on the inflationary pressure. Despite these measures, inflation has refused to go away; its pressure has not yet been abated.

During his annual state of the union speech, President Girma Woldegiorgis indicated that fighting inflation will be the chief concern of the government in the 2011/12 fiscal year. He has vowed that the government will do everything possible to bring down inflation to a single digit soon.

Yet, whether it is possible to attain single digit inflation and there is a framework in place to attain it, it remains uncertain.

With inflation hovering and expectations remaining high, obtaining an easy answer to such a million dollar question is unimaginable.

Indeed, inflation provides an important insight on the state of the economy and the policies that govern it. Stable inflation provides impetus for economic growth. There is no doubt that stable prices are good for healthy economic growth.

There is no economic theory that states that an inflation rate of five per cent is better than one of 15pc. It is the structure of the economy that determines the threshold of healthy inflation.

Ethiopia has a chronically supply constrained economy with excess demand. Increasing government investment in infrastructure, rapidly growing private consumption, influx of foreign capital, and remittances have all exacerbated demand that outsprints supply at a haggle speed. Much of the resulting growth is gulled by real estate investment and property market.

Ethiopia's economy lacks financial depth and highly liquid marketable financial instruments. Domestic investment tends to get channeled into non-productive sectors over productive ones, which could have helped in correcting the imbalance between demand and supply. In a situation where there is a dearth of savings instruments to which people can turn, prices for consumer products tend to rise, creating ground for an inflationary spiral.

Addressing the demand and supply imbalance and spurring long-term growth requires vigorous infrastructure investment.

Infrastructure is a capital stock that provides public goods and services. It creates an environment for productive activities and allows wider movement of goods and people. It helps to commercialize and diversify the economy. Squeezing infrastructure spending to curb inflation does more harm than good to the economy.

Correcting the rise in food prices will also require structural changes in food production. This, on the other hand, requires increasing agricultural activities. Until meaningful and radical output increasing measures have taken root, it is hardly possible to head off inflationary expectations.

In the face of a chronic structural bottleneck and the need for increasing infrastructural investment activities, a single digit inflation target is neither attainable nor desirable. Curbing inflation must walk hand in hand with growth, as neither can walk alone to a useful end.

Instead of burdening itself with the task of achieving single digit inflation in a short span of time, the government would rather opt for moderate inflation ranging between 10pc and 15pc until the gap between demand and supply closes.

There is no way to escape economic overheating the best possible approach; would be to pursue a path that gradually takes the economy from an overheated to a sustainable growth track.

Quite a number of people argue that the goal of achieving single digit inflation is an obligation imposed by the International Monetary Fund (IMF). Unless the country obeys this rule, access to Balance of Payments (BoP) support will be denied.

However, the IMF’s article of agreement IV notes, “each member shall endeavor to direct its economic and financial policies towards the objective of fostering orderly economic growth with reasonable price stability, with due regard to its circumstances.”

The preamble expects monetary policy tools to simultaneously attain reasonable price targets and orderly growth. It does not specify quantitative targets.

There is no presumption of the suitability of a single digit target that is universally applicable as country specific circumstances are equally important.

A nation can endure moderate inflation rate in the medium term without destroying its long-term economic prospects. Japan, for instance, experienced high to moderate inflation for several years after World War II. Yet, it liberated itself from that pain and went on to become an economic juggernaut for many decades. Similarly, inflation plagued Brazil during the early 1990s, but it is one of the strongest emerging economies today.

The Ethiopian government has taken a litany of measures in the past to tame inflation and bring it to a single digit level, including increasing the reserve ratio, capping credit, increasing interest rate on deposit, and a price cap. Despite all the available monetary policy and market intervention measures, inflation has refused to release its grip in the economy.

Although fighter monetary policy would help to anchor expectations and help commodity price spreading in to the wider economy, it alone is not sufficient to completely stop the runaway inflation as long as demand continues to outpace supply. Economic stability and achieving acceptable, moderate inflation is a continuous challenge that demands comprehensive approach. The fight necessitates holistic and calibrated policy action.

Solid and coherent monetary, fiscal, exchange rate, trade and market intervention mechanisms are required to arrest inflation to a single digit level. Doing so is time consuming and requires patience.

What policymakers are advised to do is develop the ability to detect inflation and other macroeconomic instability situations. These, in turn, will entail putting in place and continually updating state of the art methodologies and tools for measuring, forecasting and analyzing price movements and other sources of macroeconomic instability. Apart from instituting a robust monetary policy, policymakers should also revamp existing institutions and help them build flexible and effective capabilities. It is also essential to create more effective sterilization mechanisms and more productive economic bases to channel and observe financial resources. 

Above all, the best shield against a rampant inflation is to address the structural flaws of the economy and persistently tackle the imbalance between aggregate demand and supply. While the administration has so far managed to steady the growth, the next step is to increase potential growth and close the output gap.

Until the economy gradually moves from overheated to sustained growth, targeting a moderate and acceptable inflation is better than an unattainable single digit inflation level.  Running a country after all is about making choices, and each choice has a price. The price one is prepared to pay determines the choice and the course one wants to follow. The public too should understand that moderate inflation is a price to be paid to achieve sustainable and long-term growth.

By Eyob Tesfaye (PhD)
He is a macroeconomic analyst and former head of the Public Financial Institutions Supervising Agency (PFISA) 

 
 
 
   
   
   
 
 
 

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