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Making things harder for themselves
In some cases it becomes too hard to fight with inflation by changing interest rate policy. This applies particularly for the periods where inflation rate increases in parallel with the developments in the world. For instance, what can you do if the price of energy that you have to import increases?
In general, the attitude to take in such a situation is as follows: you examine whether or not unfavorable exogenous developments affect the expectations on the future level of inflation. If it does, i.e. if inflation rate is expected to rise in the future, contacts will be signed accordingly and wages, interest rate, and input prices will tend to rise. In general, interest rates are pushed to avoid this hoping that such a policy change will give the impression that the central bank "did what it had to" and will limit the deterioration in expectations.
You can only hope, because there is no guarantee that the deterioration will be eliminated. But, what if the upward trend in inflation stems from a domestic policy? Let me make an introduction to clarify what I am trying to ask: fight with inflation cannot be left to the central banks. If it is, the fight will be lost. If the fiscal policy does not assist the monetary policy, central banks fail in the fight against inflation no matter what they do. So, let us ask the question again, but this time more clearly: if the government is pursuing a fiscal policy that does not assist the fight against inflation, what can the central bank of the country do?
If they increase interest rates, does it work? Of course it will give the impression that it is doing its duties. But what should actually be done is to call the government for changing the fiscal policy to a line in parallel with the inflation, is not it? And such an attempt can only be successful if it is done openly before the public.
The last inflation report published at the end of January says in the section 'medium-term projections' say (p 91): "The tax adjustments, effective January 2010, on fuel, alcohol and tobacco to restore fiscal balance will add around 1.5 percentage points to 2010 CPI inflation. In October 2009, we assumed that prices of these products would be increased in line with the inflation target and projected a total contribution of 0.5 percentage points to CPI inflation (Table 7.1.1). Accordingly, tax adjustments in January have shifted the inflation forecast path by around 1 percentage point upwards throughout 2010."
In the "public finance" section the same report says (pp 80-81): "The government expects to increase the budget revenues-to-GDP ratio basically by indirect tax revenues. Accordingly, the Special Consumption Tax (SCT) on fuel products, tobacco, and alcoholic beverages has been dramatically hiked since early 2010."
The first quotation translates as follows: tax rates increased highly above the expectations of the central bank. And this distorted the inflation estimate of the Central Bank. Inflation target in 2001 was 6.5 percent and the distortion caused by tax increases was 1 point which is quite high when compared with the target itself. The second quotation states that the government targets to improve budget revenues through indirect taxes in 2010. That is, it implies that the price of fuel or electricity you use may rise. To put it differently, the report implicitly talk about a development that can make an upward pressure on inflation. The report only makes 'findings' about the fiscal policy. However, the current state and the upward trend in inflation require more. For instance, the report could have said: "For a couple of years following 2001, the main challenge was reducing the public debt as soon as possible. In this context, how to secure fiscal discipline was of secondary importance. But when the low level of public debt and the striking fall in the risk premium are considered, now how to secure fiscal discipline poses importance. In other words, accounting the quality of the fiscal discipline is a must for the fight against inflation." Of course, this is just an example.
However, the only 'warning' the report mentions is as follows (page 87): "It is important to solidify commitments of fiscal discipline and bring debt rollover ratios down to reasonable levels in the upcoming periods, as projected in the MTP." I want to apologize from my friends working at the Central Bank, but this warning is barely sufficient. I am afraid they are making lives harder for themselves in terms of the credibility of monetary policy and the future of the interest rate policy.
This commentary was published in Radikal daily on 12.04.2010