RATE HIKES by central bank to curb inflation have been recently witnessed throughout Asia.
A question was raised by the public; i.e., do monetary authorities place too much emphasis upon inflation? For most people, the causes and impacts of inflation may remain rather difficult to understand, but what people realize is that that they will have to live with higher interest expenses such as credit card charges or overdraft lending rate, right after interest rate has been increased to curb inflationary pressures.
Before we can fully understand the impacts from inflation, first we need to understand the role of monetary policy maker. Central bank works in a similar way to a taxi driver. When passengers get into a cab, the taxi driver has to accomplish two missions; i.e., to get the passengers to their destination as fast as possible and to ensure safety. Nevertheless, sometimes these two goals are contradictory while achieving them simultaneously could post quite a challenge to the driver.
When a central bank decides to determine interest rate direction (i.e., to conduct monetary policy), it has to balance between two goals: growth and stability.
During an economic recession, people lose confidence and reluctant to spend and invest. Central bank then steps in, cutting rates to stimulate economic activities and induce more growth.
On the contrary, if the country is growing too fast beyond economic potential or maximum capacity the economy could accommodate, excess 'demand' will hence drive up the price. Inflation, when it is high and persists, could destabilize an economy and hinder sustainable growth in the long-run. With this regard, central bank would tighten monetary policy by raising interest rate with an aim to slowdown domestic demand.
While it is comprehensible that central banks need to take care of growth; to better understand why inflation also deserves great emphasis from monetary policy maker, let's take a close look at the causes and costs of inflation in details.
Normally, when there is too much money is chasing too few goods ; i.e., the quantity demanded for goods is greater than quantity supplied in the market, or 'excess demand', then price of goods increases, it is called 'demand-pull inflation'.
Also, inflation may result from the 'cost-push' factors: the sudden rise in cost of production, given demand for goods and services remain unchanged. Increase in wages or import price of raw materials such as fuels obviously incur additional expenses to manufacturers, who, in turn, shall fully or partially pass ontoconsumers via retail price increase.
So, now we have inflation, but what costs would high inflation incur to an economy? First, inflation is like a tax on money, it erodes purchasing power of banknotes people hold. For example, 100 THB could buy 5 kilograms of rice today but may only buy only 1 kilograms of rice a year after. Inflation creates losses to savers.
Second, high inflation introduces uncertainty for businesses and consumers about future outlook. Being unable to estimate future costs as well and profits, business owners are less likely to invest more on productive projects or business expansion plans, which ultimately lead to slower economic output and longterm growth, accordingly.
Third, inflation results in higher cost of domestic product relative to overseas price, and then lowers export competitiveness of the country.
In addition, inflation widens income gap between the rich and the poor. People living off a fixedincome earning such as retirees or poor unskilled labor would suffer more in a high-inflation environment as it is very hard to raise daily wage while the wealthy individuals can protect themselves by investing in 'inflation-hedge' assets such as gold and home properties.
In summary, inflation is actually a sign that an economy is growing: a lack of inflation could hint that an economy is deteriorating. Therefore, economists perceive mild inflation as acceptable economic phenomenon. But when inflation persists and distorts prices and economic behaviors, it is labeled as a bad process. To ensure economic stability and sustainable growth, it is under central banks' major concerns to control the presence of inflation within acceptable level.
The opinions expressed in this article are the author’s own and do not necessarily reflect the official opinion of the Bank of Thailand.