The non-economist view of inflation

In today’s turbulent world, one is bombarded with many economists’ views of economic matters. For the layperson, there is much confusion as to the actual matter in the midst of all the smoke.

One of the top headlines today was the failure of Turkey to stem the steep decline in its currency the Lira. Many attributed the drop in the Lira to the failure of the central bank to raise interest rates. It was reported that the reason behind the decision not to raise interest rates was the belief of President Recep Tayyip Erdogan that raising interest rates would cause inflation to rise.

Most economists would argue that the situation should be the other way around. That is raising interest rates would help to control the rise of inflation. If so, then isn’t it obvious that President Recep Tayyip Erdogan had got it totally wrong?

When I was much younger, I always thought that raising interest rates would create even greater inflation, much like President Recep Tayyip Erdogan. Today, on hindsight, my opinion has changed. This does not mean that I agree totally with the views of the economists. In my opinion, inflation is not a simple thing to measure. Furthermore the causes and effects of inflation are not that clear.

Normally the prices of goods rises when there is higher demand than supply. The higher demand comes about when more people want to purchase these goods compared with a period earlier. Due to the higher prices, workers would demand for higher wages to maintain their standard of living. Thus the central bank then steps in to raise interest rates to prevent the economy from overheating.

However prices may rise due to a supply problem. This happens when the price of gasoline rises due to an OPEC decision. Or the prices of automobiles rise due to tariffs imposed by the United States on imported steel and aluminium. In other words, the price rises here are not due to higher demand but for other reasons. Suppose during this period, prices of other goods are relatively stable as demand is normal. However the gasoline and automobile price rises would lead to higher inflation numbers. As a result, central banks would then raise interest rates to contain it. With higher interest rates, manufacturers and service providers faced with higher costs would be compelled to increase prices to maintain their profit margins. This may be exactly what President Recep Tayyip Erdogan feared and rightly so.

Over the last decade or so, most countries in the world supposedly had low inflation. As a result, interest rates were also low since central banks do not see the need to raise them in the light of benign inflation. However asset prices like property rose much higher than the rate of inflation during this period. Even though rents did not move up that much, the higher property prices were arguably justified by the lower yield expected with low interest rates.  At the same time, the income share of the top 10% of income earners in countries like the United States rose to as much as 50%. In an article at the Guardian on Aug 15, 2018, the High Pay Centre’s Annual Review reported that CEO’s pay for the top FTSE 100 companies rose by a median of 11% in the UK in 2017. In contrast, average workers’ wages rose by only 1.7% for the same period.

If middle income wage earners had such a substantial rise, there would be a corresponding jump in interest rates. In fact, the interest rate rise would come before it happened as it would be positioned as preemptive to prevent the economy from overheating. However the rapid rise in the incomes of top income earners did not register at all with inflation indicators. The basket of goods used to measure inflation has limitations.  It would not show a significant rise in this case. The top 10% income earners would not likely purchase more food or pay higher rents or incur higher transportation costs when their incomes rise significantly. Even if they did, their number would be too small to create an impact in the inflation numbers. However they may purchase another property or luxury cars, handbags, yachts or private jets. If the prices of these items rise due to higher demand, they would not appear at all in the inflation numbers. Like it or not, there is high inflation in terms of income levels and goods at this tier. It is just not captured at all.

In conclusion, the way inflation is measured and then used by central banks to decide on interest rates leaves a lot to be desired.