Inflation dynamics and its effects on economy

by: Prof. Yeah Kim Leng, Director of Economic Studies Program at Jeffrey Cheah In­stitute on Southeast Asia

After nearly two years of low consumer prices and falling pro­ducer prices, their steady rise in the first quarter of this year sug­gests that higher inflation and price shocks will once again test the resilience of households, busi­nesses and the overall economy.

While consumer price inflation edged up 4.3 per cent in the first quarter, up from 1.7 per cent in the previous quarter and 3.4 per cent in the same quarter last year, the producer price index (PPI, which measures the selling prices of domestic producers), shot up by 10 per cent from three per cent in the previous quarter and negative 4.4 per cent in the previous year’s first quarter.

Meanwhile, the broadest mea­sure of price changes for the economy, the gross domestic product (GDP) deflator, which fell by 0.4 per cent in 2015 before edging up to 1.9 per cent last year, is also pointing to the rising price pressures, with the fourth quarter of last year showing an increase of 2.8 per cent com­pared to average annual increase of one per cent over the last five years.

End of low inflation era?

Unless advanced economies are able to sustain higher growth, consumer price inflation in these countries will remain subdued and below the two per cent tar­get. Consequently, their role as a part of the global factors con­tributing to inflation in devel­oping economies will remain be­nign over the next few years.

Given ample global production capacity and supplies, the low inflation in advanced economies will end only when domestic de­mand surges more strongly.

Demand has been held down by persistent unemployment, age­ing population, weak productiv­ity growth, and cautious senti­ment amid ongoing geo-political uncertainties.

Nevertheless, the more posi­tive and synchronised growth globally that marked the start of this year is a healthy sign that global demand may be on a more sustainable upward trajectory that could herald a modest in­flation environment.

Inflation trends in emerging economies

The low inflation phenomenon likewise characterised many countries in the developing world. Although there were bouts of inflation surges due to energy and food price shocks caused mainly by supply disrup­tions, the overall inflation rate quickly reverted to the mean for most countries.

So far, the fuel and food com­modity shocks have proved to be transitory with the underlying in­flation for most economies reverting to below historical trends. This low inflation per­sistence has been one of the key features of developed and de­veloping economies compared with inflation performance in the past decades.

A major factor contributing to low inflation in emerging coun­tries, including Malaysia, has been globalisation. The rise in globalisation has created posi­tive incentives for policy makers to maintain prudent monetary and fiscal policies that kept in­flation in check.

Similarly, trade openness has resulted in the decline of price levels as producers become more efficient. Cheaper imports also substitute more costly local goods and services.

The deepening of domestic fi­nancial markets likewise has en­abled the economies to absorb larger trade balance deficits and surpluses, thereby reducing the effects of domestic supply and demand imbalances on prices.

How serious is the recent in­flation surge?

The phenomenon of weak in­flation persistence suggests that Malaysia’s above trend CPI in­crease in the first quarter is ex­pected to taper off in the second half of this year and normalised to the two-three per cent level next year in line with expected decline in world oil prices.

The mean-reverting inflation behaviour is conditional upon sta­ble inflation expectations whereby there are little knock-on effects on the broader array of goods and services in the economy.

The absence of second or third round price effects appears to be holding up as the underlying inflation as measured by the core inflation index thus far has re­mained well-anchored while demand-pull price pressures re­mains subdued.

On the contrary, the price pres­sures faced by domestic produc­ers remain a concern, notwithstanding the fact that rising prices may also indicate better pricing power and top line sales performance for suppliers.

A closer look at the disaggre­gated prices shows that the in­creases were largely accounted for by the sharp rise in the prices of raw materials and interme­diate products.

The profit margins of individ­ual producers, therefore, will be determined by the extent their production is affected by the rise in input prices, the ability to pass through the cost increases and the benefits they can reap from higher production and produc­tivity gains.

For consumers, the expected downtrend of headline inflation from April onwards is positive news, but offers little consolation to households facing stagnant wages or income.

For example, a three per cent annual inflation over five years will result in a 16 per cent decline in the real income or purchasing power if there is, no accompa­nying rise in nominal income.

While the total number of households facing stagnant wages continue to shrink, it is important that more targeted measures are in place to mitigate the negative effects of inflation even at low levels on the affected households.

By Prof. Yeah Kim Leng | 19 May 2017 

Professor Yeah Kim Leng is the Director of Economic Studies Program at Jeffrey Cheah In­stitute on Southeast Asia at Sunway University and Professor of Eco­nomics at Sunway University Business School. He is also an external member of Bank Negara Malaysia’s Monetary Policy Committee. The views expressed in this article are his own.

First appeared in the New Straits Times

Modified by Low Wai Sern