Inflation in 2003: Cancer or Growth Serum?
Ever since hyperinflation swept the country in 1992-1993, Ukraine tends to be wary of price hikes, treating inflation as an absolute evil that should be fought without mercy. However, the possible consequences of inflation — both negative (lower purchasing power) and positive (production and GDP growth) — depend on specific economic processes. Thus, inflation under certain conditions can be either a malignant tumor or growth serum. For this reason, the public should be informed in time about the circumstances that cause it.
At present, the EU considers it good manners in the economy to have an inflation rate of 0-2%. Meanwhile, under the Maastricht Treaty the annual inflation rate for EU members cannot exceed the average inflation rate in the three EU countries with the lowest inflation by more than 1.5%. Moderate inflation augurs economic growth accompanied by a low level of economic imbalance between the money supply, goods market, and various sectors of the economy.
The inflationary spiral in Ukraine was caused by many factors. Before 1996, inflation was primarily caused by NBU monetary emissions designed to offset the budget deficit. Structural disproportions of the economy (the disparity between the production structure and social needs), a high level of GDP redistribution via the state budget (high tax pressure forces producers to raise prices), as well as the dominance of indirect taxes in Ukraine’s tax system, foster inflation. This year alone VAT, excise tax, and customs receipts are expected to reach UAH 25.24 billion accounting for 75.7% of tax revenues or 50.46% of all budget revenues. The main drawback of indirect taxes is the fact that by inflating the prices of goods they flame inflation.
NONMONETARY PHENOMENA
What are the causes of inflationary processes we witnessed in the first quarter when the consumer price index came to 103.7% (101.5% in January, 101.1% in February, and 101.1% in March), which drew criticism from President Kuchma?
“Inflation is invariably a monetary phenomenon,” wrote famed economist Milton Friedman. However, the dynamics of changes in the volume of monetary aggregates in the first quarter of 2003 is evidence that inflation (much as deflation of 2002) has not been caused by the monetary policy of the NBU (see chart).
As can be seen from the chart, in the first quarter of 2003 the increase in the volume of cash on hand and monetary base was substantially smaller than in the first quarter of 2002. The volume of cash on hand even decreased. The money supply in fact increased at the rate twice that of the first quarter of 2002. However, the highest inflation rate in the first quarter was recorded in January (1.5%), while the money supply in that same month decreased by 2.6%.
The analysis suggests that the groundwork for this year’s inflation was laid last year. In 2002 the key inflation indexes, the consumer price index (CPI) and producer price index (PPI), behaved in a diametrically opposite ways, with the former decreasing by 0.6% and the latter rising by 5.7%. Unfortunately, economists overlooked this. First, these different trends burdened our trade, which acts as an intermediary between producers and consumers. Second, a higher wholesale price index could not help but affect the CPI.
Notably, this year both indexes behave in like manner. However, the CPI growth rate (3.7%) is a little ahead of the PPI (3.3%). Thus, traders are gradually making up for what they lost last year.
Another interesting trend is seen in the fact that last year’s fourth quarter proved the most inflationary, with the CPI rising from 97.4% to 99.4%. During that same quarter, the highest GDP growth rate was recorded (6.1% up from the same period of 2001), which raised the yearend GDP growth rate to 4.8%.
ARGUMENT OF GDP
The first quarter of 2003 saw a quite substantial GDP growth rate (up 7% from the same period of 2002). This tallies with the concepts of Keynesian economics, which maintains that under conditions of an economic slump and recovery the GDP growth rate is tied to the inflation rate. Moreover, inflation is useful and even indispensable for economic growth. In the 1950s, economists noticed an interdependence among production growth, the unemployment rate, and inflation rate in the short term. Thus, the dynamics of changes in the GDP and inflation rate adjusted for the unemployment rate (according to the State Statistics Committee, the unemployment rate did not change substantially in the first quarter) can be shown by parallel curves. Moreover, GDP growth is tied to the increase in the coefficient of use of production capacities, which is also adjusted in direct proportion to the changes in the inflation rate.
SOCIAL FACTOR
Economics is only seemingly distanced from other social sciences. Many of its laws are based on the social specifics of man as “a social, political, and economic being.” Social psychologists even speak of the so-called Pygmalion effect whereby such phenomena as forecasts, prognoses, and expectations shape the future reality.
Is it bad or, conversely, good that, embarking on the process of forming the budget for 2004, the government is following a conservative scenario as a basis for planning budget items for 2004? This scenario, submitted for consideration in the parliament as part of the report, On the Main Directions of the 2004 Budget Policy, envisions an inflation rate of 7.2% for this year and 6.3% for 2004. The producer price index is expected to rise by 8.3% and 5.1% in 2003 and 2004. Meanwhile, the hryvnia-dollar exchange rate is expected to reach UAH 5.35 against USD 1 in 2003 and UAH 5.52 per US dollar in 2004. Estimates for the conservative scenario have been made using the current legislative tax base. Such a scenario is possible should socioeconomic development risks materialize. Significantly, the economy will continue its upward movement largely owing to the impetus it received in the past couple of years. Simultaneously, the government’s targeted scenario envisions the enactment of legislation designed to ease the tax burden, while consumer demand is expected to remain the key factor of growing domestic demand. According to government forecasts, real GDP growth will reach 6% in 2003 and 8% in 2004. According to this scenario, inflation growth rate will reach 6% in 2003 and 5.8% in 2004, and producer prices are expected to increase by 7% and 6% in 2003 and 2004 respectively. However, according to The Day experts, Ukraine’s economy is presently threatened not so much by inflation as by the repetition of the deflationary trends of the past year. Authors of the feature carried below forecast the scenario of government actions under such conditions.
Ever since hyperinflation swept the country in 1992-1993, Ukraine tends to be wary of price hikes, treating inflation as an absolute evil that should be fought without mercy. However, the possible consequences of inflation — both negative (lower purchasing power) and positive (production and GDP growth) — depend on specific economic processes. Thus, inflation under certain conditions can be either a malignant tumor or growth serum. For this reason, the public should be informed in time about the circumstances that cause it.
At present, the EU considers it good manners in the economy to have an inflation rate of 0-2%. Meanwhile, under the Maastricht Treaty the annual inflation rate for EU members cannot exceed the average inflation rate in the three EU countries with the lowest inflation by more than 1.5%. Moderate inflation augurs economic growth accompanied by a low level of economic imbalance between the money supply, goods market, and various sectors of the economy.
The inflationary spiral in Ukraine was caused by many factors. Before 1996, inflation was primarily caused by NBU monetary emissions designed to offset the budget deficit. Structural disproportions of the economy (the disparity between the production structure and social needs), a high level of GDP redistribution via the state budget (high tax pressure forces producers to raise prices), as well as the dominance of indirect taxes in Ukraine’s tax system, foster inflation. This year alone VAT, excise tax, and customs receipts are expected to reach UAH 25.24 billion accounting for 75.7% of tax revenues or 50.46% of all budget revenues. The main drawback of indirect taxes is the fact that by inflating the prices of goods they flame inflation.
NONMONETARY PHENOMENA
What are the causes of inflationary processes we witnessed in the first quarter when the consumer price index came to 103.7% (101.5% in January, 101.1% in February, and 101.1% in March), which drew criticism from President Kuchma?
“Inflation is invariably a monetary phenomenon,” wrote famed economist Milton Friedman. However, the dynamics of changes in the volume of monetary aggregates in the first quarter of 2003 is evidence that inflation (much as deflation of 2002) has not been caused by the monetary policy of the NBU (see chart).
As can be seen from the chart, in the first quarter of 2003 the increase in the volume of cash on hand and monetary base was substantially smaller than in the first quarter of 2002. The volume of cash on hand even decreased. The money supply in fact increased at the rate twice that of the first quarter of 2002. However, the highest inflation rate in the first quarter was recorded in January (1.5%), while the money supply in that same month decreased by 2.6%.
The analysis suggests that the groundwork for this year’s inflation was laid last year. In 2002 the key inflation indexes, the consumer price index (CPI) and producer price index (PPI), behaved in a diametrically opposite ways, with the former decreasing by 0.6% and the latter rising by 5.7%. Unfortunately, economists overlooked this. First, these different trends burdened our trade, which acts as an intermediary between producers and consumers. Second, a higher wholesale price index could not help but affect the CPI.
Notably, this year both indexes behave in like manner. However, the CPI growth rate (3.7%) is a little ahead of the PPI (3.3%). Thus, traders are gradually making up for what they lost last year.
Another interesting trend is seen in the fact that last year’s fourth quarter proved the most inflationary, with the CPI rising from 97.4% to 99.4%. During that same quarter, the highest GDP growth rate was recorded (6.1% up from the same period of 2001), which raised the yearend GDP growth rate to 4.8%.
ARGUMENT OF GDP
The first quarter of 2003 saw a quite substantial GDP growth rate (up 7% from the same period of 2002). This tallies with the concepts of Keynesian economics, which maintains that under conditions of an economic slump and recovery the GDP growth rate is tied to the inflation rate. Moreover, inflation is useful and even indispensable for economic growth. In the 1950s, economists noticed an interdependence among production growth, the unemployment rate, and inflation rate in the short term. Thus, the dynamics of changes in the GDP and inflation rate adjusted for the unemployment rate (according to the State Statistics Committee, the unemployment rate did not change substantially in the first quarter) can be shown by parallel curves. Moreover, GDP growth is tied to the increase in the coefficient of use of production capacities, which is also adjusted in direct proportion to the changes in the inflation rate.
SOCIAL FACTOR
Economics is only seemingly distanced from other social sciences. Many of its laws are based on the social specifics of man as “a social, political, and economic being.” Social psychologists even speak of the so-called Pygmalion effect whereby such phenomena as forecasts, prognoses, and expectations shape the future reality.
Thus, after the NBU governor was replaced, politicians stated publicly that they feared a possible devaluation of the hryvnia and even uncontrolled money emissions. This scare was taken further by the government considering an issue of Gas of Ukraine bonds with a maturity of ten years to the amount of UAH 3.5 billion and an interest rate of 8%. Considering the amount and conditions under which the bonds were to be issued as well as the fact that October 2002 saw the beginning of the Gas of Ukraine bankruptcy procedure, international financiers and the NBU interpreted the government’s idea as a call for a veiled emission.
Despite the numerous statements by NBU representatives to the effect that there would be neither devaluation nor emissions, enough seeds of doubt had been sown, resulting in increased inflation fears that could affect the behavior of consumers who would begin to spend more money to jump on the price bandwagon that was about to depart.
CONSUMER BASKET
Research suggests that the recent increase in the CPI was primarily due to higher prices of foodstuffs (5.2%), with major leaps in the prices of vegetables (53.1%), potatoes (22.8%), and fruit (22.7%). Despite the fact that price hikes involving seasonal types of produce are especially pronounced in January, these types of foodstuffs account for a considerable share in the structure of the consumer price index. Thus, for example, according to statistics, an average Ukrainian spends 2.91% of his income on potatoes.
Prices have grown for such critical foodstuffs as bakery products (1.4%), with white bread alone accounting for a 5.508% share in the CPI structure and sugar (4.6%) with its 3.847% share in the CPI structure. Simultaneously, prices for meat products decreased by 4.2%, with pork and beef accounting for a 4.561% share of the CPI, and by 13.3% for eggs (2.589% of the CPI structure). Sunflower oil (2.115% of the CPI) prices decreased by 1%.
The plight of the grain market could also be a major factor of higher inflation. The fact that most winter crops have been damaged, with the resulting higher costs of the seeding campaign (farms must buy 64 additional tons of seeds to reseed 500-600 thousand hectares of winter crops) does not bode well for the future crop. These forecasts have caused prices for grain and flour products to climb even now. Prices for flour and pasta products have increased by 17.3% and 3.8% respectively. As a result of lower production of cereal crops, prices for cereals and legumes have risen 22.1%.
Prices for services have also increased by 1.4%. The CPI for electricity, gas, heat, and water supply has increased by 2%. Incidentally, electricity and heating bills eat up 6.243% of an average Ukrainian’s income.
Prices for nonfood products have remained quite stable, up only 0.2% from last year. Meanwhile, although gasoline prices have decreased by 2.3% they are expected to rise because of higher oil export duties imposed by Russia. However, this change is of primary concern not for average consumers (who account for a mere 0.463% of fuel consumption) but for producers and sellers, because fuel price changes can affect transport costs. Incidentally, the costs of railway transport of goods account for a major share in the CPI increase. In early January 2003, they rose by 5-10 percentage points and for oil transport by 27 percentage points.
THEORY AND PRACTICE
According to Milton Friedman, inflation can be prevented simply by reducing the growth rate of money supply. But is this really necessary? The example of Argentina in 1992-1999 is illustrative in this respect. The Argentinean government reduced money supply growth rate from 62.5% to 4.1% thereby reducing inflation from 24.9% to a deflationary level of 1.2%. However, while in 1992 Argentine experienced an economic upturn, with the GDP reaching 11.9%, 1999 marked the beginning of an economic slump, with the GDP plummeting to 3.2%. We remember from the news what this led to in 2001. Thus, money supply for the economy is like vitamins for the organism: both their shortage and excess damage the health of an economic organism.
Meanwhile, the monetary policy for 2003 envisions increasing the monetary base by 17-20% and money supply by 22-27%. This means that the planned monetary aggregates’ growth rate for this year has been reduced almost twofold. Considering the inadequate monetarization of the economy as well as the fact that a higher inflation has been caused by events beyond the competence of the NBU, it would not be worthwhile to further reduce the volume of monetary aggregates, since an abrupt decrease in the money supply growth rate could result in slower economic growth.
In our view, it is primarily up to the government and not the NBU to prevent the growth of inflationary pressures. First, it should not increase sharply electricity, transport, and utilities fees. Second, the government must stabilize the grain market and provide adequately for the sowing campaign to enable farmers to harvest the 38 million tons of grain planned under the 2003 Grain Program. Third, government and NBU representatives alike must refrain from any statements that could arouse inflationary fears. These will help contain inflation within the 10% bracket in 2003. However, restricting inflation should not be viewed as an end in itself. Since, come what may, under the present economic conditions the top priority for Ukraine should be economic growth and not combating inflation.
