Credible Announcements for Low and Stable Inflation

Abis Getachew Makuria, executive committee member of Ethiopian Democratic PartyBy Abis Getachew Makuria

The recent occurrence of the price increase in consumers’ commodities is expected to raise the general inflation which was at a single digit for the last 15 months. Though the government put the blame on business community, the recently observed inflation across the nation is consistent to the existing theories of inflation.

Milton Friedman’s long lasting theory of inflation states that general price increase is highly determined by expectations. Robert Lucas widen the concept that these expectations are not only formed by past information but also based on current information from media, press, reports and government announcements as well.

The recently observed inflation highly attributes to change in expectations. These changes are mainly driven by the mechanism in which the budget deficit for the year 2014/15 is regulated and by the governments’ announcement of wage increase for the civil servants. These two recent economic phenomenons led to changes in expectations of inflation among economic agents. In this article I will try to discuss how these two economic occurrences have led to a rise in the general prices.

Before the legislative approved the 2014/15 budget, the media were stating that the budget deficit will be financed through the sell of the treasury bills and borrowing of the central bank. Though financing the deficit through TBs sell weakens and crowds out the private investment it might not necessarily lead to inflationary pressures. However, the announcement of borrowing from the central bank to finance the deficit will have an impact on inflation expectations and hence inflation.

In a country where the central bank is at the hand of government it is very hard for the pubic to trust government announcements about the money supply and borrowing. Economic agents are also uncertain whether the government is borrowing the right amount from the bank. In such a situation, if the government itself makes it public that it will borrow from the central bank to finance its deficit, then it is obvious that expectations about inflation will rise. This will then have a direct and immediate impact on prices too.

In addition, the shift in expectations is not uniform since the prices of same items in same markets vary here in Addis Ababa. From this one can understand that expectations are formed from personal judgement than the government announcement. Moreover, one can clearly see that economic agents do not have confidence on government announcements because if announcements have been trusted then the price increase could have been uniform.

If our country was blessed with strong labour unions and consumers cooperatives, they would have also faced the same problem in adjusting their wages and prices, respectively. This is mainly due to blurred view on the new money that will be injected into the economy. Because of such unclear information, economic agents could not set their share in the economy given the nations’ total output.

To remove the problem of higher expectations of inflation that is associated with the budget deficit, government should take measures of making the central bank independent. If the central bank is independent from the hands of executive and accountable to the legislative, then the public confidence raises that the incumbent government will not borrow money as it wishes.

Though it is hard for a developing country such as ours to have a fully fledged independent central bank that targets inflation, at least it is possible for the government to offer partial independence for the bank by making it accountable to the legislative and providing it freedom of choosing policy instruments. On the other hand, the goal can be set with national consensus through negotiations between representatives of economic agents such as the business
community, labour unions, consumers’ cooperatives, government, etc… This point should be scientifically confirmed too. In other words, this is the level of inflation that facilitates growth at its optimum level. In such a case, the central bank will not only have a single goal of inflation targeting but also will have a goal of economic expansion. Hence, once the goal is set the central bank should be independent in choosing monetary policy instruments which is coherent to other policies in order to achieve the threshold level of inflation. In addition, to strengthen the check
and balance the central bank should be accountable to the legislative body of the government. Hence, inflation expectation due to budget deficit adjustment can be solved in such a way.

The second phenomenon that triggered the inflation expectation is the governments’ announcement of the nationwide wage increment for the civil servants. Though the government argues that the scale is not even announced to raise the inflation level, the announcement alone is adequate to trigger expectations.

An increase in the wage level should be appreciated. However, if the increment or the announcement is not associated with productivity and improved service provision, then it will lead to sever inflation and economic chaos. In our everyday life we witness the increasing corruption, mal administration and the mix of governmental and party doings in the civil service which is partial evidence that productivity and service provision of the civil service is
deteriorating through time. Thus, economic agents adjust their inflation expectations to the higher level due to the belief that new money injected into the economy without improvement in productivity.

Though the initial intention of the government was to improve the living condition of the civil servants but the opposite effects are already being witnessed. Therefore, the bottlenecks of the civil service should have to be resolved and it is necessary to create a productive environment at the civil service before the wage increment. At least, such measures could create trust among the public that the salary increase is consistent with improved productivity.

However, creating a productive environment and removing the bottlenecks of the smooth functioning of the civil service may take time. Thus, these policy measures could be taken as long term solutions. In the short run, pro urban poor measures can be taken to ease the cost of living such as subsidizing major consumption items like kerosene and selected cereals too.

In general, the expectation on inflation is the main source of the recently observed inflation. To lower expectations of the public the government is announcing every time that there is no ground of inflation to occur in the country. It further points finger on few greedy and irresponsible traders. In my opinion, traders are of course few compared to the total population of the country but few among the traders can not create nationwide inflation. Hence, government should focus on making its announcements to be credible. For government announcements to be credible there have to be measures to be taken like the move to have partially independent central bank and creating conducive environment to promote productivity and remove the supply side problems.