Inflation has sky-rocketed

The current crisis is much worse than people think. There will be a relatively long period of misery for many before any chance of a real economic turnaround. As an academic without a political agenda, it is my job to give the public an honest take on the magnitude of the current economic situation and the possible outlook for the near future.

Let’s start with the obvious - the reasons for this unprecedented surge in price of goods and services. First, the incredibly foolish idea of printing money. Yes, someone actually had the idea to print the Sri Lankan Rupee as if it was the US dollar. As a consequence, the currency price decreased and import costs increased. Second, the supply disruptions from the COVID-19 pandemic. Third, the rise in the oil prices from the Ukraine-Russia conflict. Fourth, the irrational tax cuts which increased the demand for goods and services in a time of supply shortages. Fifth, the rash agricultural policies implemented by the government. There’s more but let’s stop here for brevity.

Unless you believe that the UkraineRussia conflict ends and oil prices drops immediately and, for some magical reason, the speculators view the Rupee as a safe haven currency in these high uncertain times, these inflationary pressures will be more persistent than transitory in nature.

Is the situation that bad? Well, let’s just look at the numbers. The current official inflation rate is around 22 per cent and the interest rate set by the Central Bank is below 15 per cent. Do you see a problem? The real interest rate, which is the interest rate adjusted to remove the effects of inflation to reflect the real cost of borrowing, is approximately negative 7 per cent. In reality, we are probably looking at double digit negative real interest rates since the actual inflation is likely well above 22 per cent. In this environment, money has little value. Households and investors are better off spending the money now than saving or investing it. This is going to put even more pressure on prices, which will further increase inflation.

As explained by the leading financial economist John Cochrane in a series of recent academic papers, inflation today is also impacted by the expectations of future inflation. Does anyone believe that the current or any potential interim government will allow the Central Bank to fight inflation long-term with policies that might hurt their reelection campaigns? This is unlikely. Supporting longterm plans for a better future is not something we have seen much in Sri Lankan politics. Hence, people have no credibility that inflation will be controlled in the future. The inflationary pressure from failed economic policies, supply disruptions, combined with high future inflation expectations equals even higher inflation in the short-term. Are we starting to see a problem?

The Central Bank has to make a very unpopular decision assuming it is even allowed to do so by politicians who should have no role in meddling with monetary policy in the first place. The Central Bank needs to increase the interest rates well above the inflation rate. This will hurt many households and businesses. Why? Higher interest rates mean higher payments on housing, car loans, personal loans etc. Higher interest rates mean higher borrowing costs for businesses that are already struggling. Higher interest rates mean lower real equity returns. Not only that the Central Bank needs to increase the rates, but it needs to keep the interest rate high until the inflation rate drops below the target threshold.

By the way, we are not done with the bad news. Governments throughout the recent history have used debt financing as a substitute for taxation because it has the political advantage of generating an immediate benefit for the voters without incurring an immediate cost. Now, the government will need to pay higher interest payments on the public debt. But with what money? Here comes the taxes on the people and corporations that are already suffering from high interest rates.

It’s time to be honest and accept the reality. To get out of this current economic crisis, it’s the people who will pay a high price. There needs to be a responsible and a competent government to tackle these economic problems. It’s time to think long-term. The Central Bank needs to control the inflation problem. The government needs to revamp the tax system to control the fiscal problem.

Yes, these actions will temporarily hurt Sri Lankans. However, suffering short-term is much better than the alternative of not doing anything. Otherwise, millions of people will suffer even more from the shortages and the rising costs for food, medicine, transportation, and housing. We are already seeing the effects and yet this is only the beginning.