Fighting Inflation

Inflation averaged 13.2 percent in the fiscal year 2008-09, 10.5 percent in 2009-10 and, according to the Monetary Policy for fiscal 2010-11, is expected to be 7 percent in fiscal 2010-11. Given the persistently high inflation in Nepal for the last couple of years, the Nepali people, I feel, have started to take higher prices as given and adjust with them accordingly. However, having said that, one needs to think about the adverse impact of an inflationary environment and its wide ranging impact on export competitiveness to national savings to the exchange rate.

But before I get into the details of the adverse impacts of inflation, it’s interesting to compare and analyze the government’s inflation projection—set by Nepal Rastra Bank at the start of the fiscal year in its annual Monetary Policy announcement—and actual inflation for that particular year.

For fiscal 2008-09, NRB had projected an annual inflation rate of 7.5 percent; but the actual inflation for that fiscal year was, as mentioned above, 13.2 percent. Similarly, for fiscal 2009-10, NRB had projected an annual inflation rate of 7 percent while the actual inflation for the last fiscal year was 10.5 percent. For this fiscal year, NRB has again projected an inflation rate of 7 percent. What the average annual inflation for the current fiscal year will be remains to be seen. However, given the central bank’s track record, your guess is as good as mine.

Given the above mentioned context of a huge gap between the projected and actual inflation

rates during the last couple of years, it’s easy to realize that

NRB has lost its credibility especially in terms of fighting inflation. Keeping the supply side constraints aside, which is the inevitable excuse that NRB uses when the actual inflation is higher than the projected inflation, if NRB has projected inflation to reach a certain level, why then doesn’t it fight to keep it at that level?

If at the start of the year, I believe that inflation will be 7 percent (guided by NRB), I will plan accordingly; i.e., if I am a wage earner, I will demand a minimum 7 percent wage hike to at least maintain the purchasing power of my income. Similarly, if I am the owner of a manufacturing company, I will increase my product’s price by a minimum 7 percent so that my firm’s profit will at least remain the same in real terms.

However, if at the end of the year, I realize that inflation actually increased to 13.2 percent, then I will be worse off irrespective of whether I am a wage earner or the owner of a manufacturing

company. Hence, at the beginning of the next fiscal year, I start to mark up NRB’s inflation projection by a certain percentage so that I won’t be worse off again. If every decision maker, i.e., individuals and businesses in the country, starts doing the same, then the inflation level will shoot up and become unmanageable.

High inflation then has a multiplier effect throughout the economy. High inflation decreases after-tax real return and reduces the people’s incentive to save and invest. For example, if the tax rate is 25 percent, the interest rate on a one-year taxable bond is 10 percent and the inflation rate is 5 percent, then the before-tax real return will be 4.76 percent, and the after-tax real return will be 3.57 percent (this is what an investor actually cares about).

Now, if the inflation rate rises by 5 percent to 10 percent and the interest rate on a one-year bond also rises by 5 percent to 15 percent, then the before-tax real return will be 4.55 percent, and the after-tax real return will be 3.41 percent.In the latter case, even if the nominal return has increased to 15 percent, the after-tax real return is lower than in the former case because of high inflation, discouraging people from saving and investing.

High inflation also makes a country’s products less competitive in the international market and reduces exports. Because of its adverse effects on exports and imports, in the long run, it also puts downward pressure on the country’s currency.

This article was first published in the Kathmandu Post on Dec 6th 2010

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