Wednesday, June 18, 2008

The Root of Inflation

Economists generally categorize inflation into 2; cost-push inflation whereby cost of main driver of good and services increases and demand-pull
inflation, whereby there is just too much demand for the goods and services, so producers increase prices to rake in better profits.

Most of us would readily identify the first cause in our current situation, ie the the price of oil in the world market increased substantially, which lead to chain effect down the production sector of the economy. If this was just before the WW2, it would not matter so much. Oil was not the main driver of production cost back then.
Lets just accept the fact that there is nothing much we can do about the price of oil in the world market. We all know that the current high prices of oil is achieved through increasing demand from newly rich economies of China and India as well as rampant speculative betting by investors in the market.
Just because our country produce oil, doesnt mean that we can demand to get subsidized petrol for years to come. What if we dont have oil, like what it was in the sixties?

Now, lets remove oil as a factor in Malaysian economy, and consider inflation.

Some of us would admit that there are elements of demand pull inflation. Next time we go to the 'pasar malam' check how traders sell their vegetables, ready-to-eat food and fresh food. How brisk is their business?
We would notice that people are more affluent these days compared to say, 10 years ago. Driving cars to work is normal, not motorbike or bicycle. Malaysia economy shift from agriculture based 20 years ago to manufacturing and services. When people get richer, they consume more, and a substantially higher portion of this consumption is on food. Notice too that obesity and 'wealthy diseases' like high blood pressure, diabetes is becoming more prevalent even in villages. So the demand for basic food has increased substantially. This is the demand pull inflation.

this article from
Consumer inflation 'could top 4%'

How one family is having to cut back in response to rising food and petrol prices
Rising food and energy prices could push UK consumer inflation above 4% this year, the governor of the Bank of England has warned.

He was speaking after the Office for National Statistics (ONS) said the Consumer Prices Index (CPI) rose by 3.3% in May, up from 3% in April.

This is the fastest rate since the CPI measure began in 1997, the ONS said.

The wider Retail Prices Index measure of inflation rose to 4.3% from 4.2% the previous month.

The biggest contributor to consumer inflation was the rising price of food and non-alcoholic drinks, the ONS said.

This was mainly due to the increasing cost of meat products, particularly bacon, and vegetables.

Increasing household energy bills were also a significant factor, along with the rising cost of books, stationery and foreign holidays. However, this rise in the cost of leisure and recreation was offset by a fall in the price of DVDs, according to the ONS.

'Considerable uncertainties'

If inflation rises more than one percentage point above the government's 2% target, the Bank of England governor must write a letter to the government to explain what action it is taking to control consumer prices.

In his letter to the chancellor, Bank of England governor Mervyn King blamed sharp rises in the prices of food and energy for the increase in the rate of inflation.

He also suggested that prices will rise at a faster rate in the coming months. DEAR MERVYN...

To return now to inflationary pay settlements would undermine rather than raise people's living standards

Chancellor Alistair Darling

"As things stand, inflation is likely to rise sharply in the second half of the year, to above 4%," Mr King told the chancellor.

"I must stress however, that there are considerable uncertainties, in both directions, around this, and any such projection is particularly sensitive to changes in domestic gas and electricity prices," he said.

Mr King has had to write such a letter to the chancellor only once before, when inflation hit 3.1% in April 2007.

The governor said that the rate of inflation should peak towards the end of this year, as long as there were no "unexpected increases in oil and commodity prices".

Should the UK avoid severe external shocks, then the rate of inflation will begin to fall back towards the 2% target next year, Mr King said.

In reply, Chancellor Alistair Darling called for "restraint" in pay rises awarded in both the public and private sector.

"To return now to inflationary pay settlements would undermine rather than raise people's living standards, with a damaging circle of wage increases eroded by steadily increasing prices," the chancellor said.

Economic slowdown

The higher-than-expected rise in consumer price inflation has transformed expectations for interest rates, according to the BBC's Economics Editor, Hugh Pym.

The global nature of these price changes is evident in inflation rates not only in the UK, but also overseas

Confident talk of two or more cuts in borrowing costs from the present level of 5% has been replaced by forecasts of unchanged or even higher rates in the months ahead, our editor says.

Mr King and his colleagues are unlikely to cut interest rates further until they are convinced that the inflationary threat has passed - despite pleas from those struggling in the housing market.

However, analysts warn that raising interest rates to curb inflation could dampen an economy already dented by slowing growth and the weakening housing market.

"The key factor [deciding the direction of interest rates] will be whether increased inflationary expectations feed through into greater wage demands and second round effects – at the moment average earnings growth is stable, but the MPC will be watching it closely through 2008," said economist Charles Davis from the Centre for Economics and Business Research.

Passed on

Consumers and companies around the world have been feeling the effects of higher energy and food bills.

"The global nature of these price changes is evident in inflation rates not only in the UK, but also overseas," Mervyn King said.

In the past 12 months, world agricultural prices have increased by 60% and retail food prices by 8%, the governor said.

Oil prices have nearly doubled over the past year and on Monday the price hit a fresh high of almost $140 a barrel in New York.

Wholesale gas prices are up by about 160% in the past year and UK household energy bills have risen by about 10%.

Those increases have prompted many people to rein in their spending in other areas.

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