Monday, May 26, 2008


Gary Becker (link) and The Economist (link) recently discussed the surge in commodity prices and inflation that has driven inflation rates in emerging markets as well as in high-income economies to historic highs. For example, China's official rate of consumer price inflation is at 12-year high of 8,5 percent. Unofficial estimates have shown that Argentina's inflation rate has peaked 23 percent in 2008. Also, inflation rate in Russia has trimmed up to 14,5 percent, up from 8 percent annually. Central banks in emerging markets have repeatedly faced significant inflationary pressures. In world market, the price of oil barrel has climbed over $120 USD which gave speculators a boost in inflating the expectations that the world price of oil barrel will reach $200 percent and more.

Using the data and some basic tools of economic analysis, it is easily shown that the real price of oil per barrel in relative terms, cannot reach $200 USD unless terrorists attack or a sudden attack on oil fields in the Middle East impairs production abilities of oil producers in that part of the world. Commodity market analysts repeatedly analyze the spillover effects of the regulation of production in oil-exporting economies that generates upward changes in the world price of oil. One reason is that OPEC is a cartel of countries whose profit-making point rests on the real assumption that price elasticity of oil demand is very low which means that there's an inelastic demand for oil. In that case, producers choose to allocate relatively scarce resources by rationing the production of oil and thus increasing the price of oil which, in real conditions of imperfect competition, yields oil producers gains since inelastic consumer demand and quantity control of the production return higher profits when the price per unit of oil is increased. One of the classical solutions to avoid higher price increases and mark-ups is to shift towards the consumption of green energy that will make the demand for commodities, such as oil, more elastic and that would immediately eliminate the monopoly power of OPEC. But the shifts towards "greener energy" is a time-taking process that involves significant consumer expenditures as the price of products that are not linked to oil as production ingredient, is high. That is because, developing "green" products demands huge company expenditures in R&D, supply chains and knowledge-intensive services. Over time, the dependency on oil is expected to decline which implies that cartel stability of OPEC which controls the quantity and price of oil in the world market will decline gradually.

Among economic analysts, the surge in commodity prices is assumed as the engine of current inflationary pressures. But world supply and demand cannot solely explain the surge in commodity product prices. Impeding price controls and export subsidies have vastly contributed to a recent surge in commodity prices. Using price controls causes disparities in quantitiy demanded and supplied which leads to quantity shortages and price accomodation in underground markets. Also, various export bans, subsidies and price controls cause significant micro-inefficiencies that raise the rigidity and potentially reduce the elasticity of demand and supply.

Another important aspect of the surge in inflation in emerging markets is macroeconomic policy pursued by central banks and fiscal policymakers. For example, China responded to inflation surge by putting up more price controls and export bans. India has suspended futures trading in particular commodity markets. In the short run, such measures can cap the official inflation but in the long run, such measures do not lead to price adjustment after the endogenous and/or exogenous shocks tranquil. One of the reasons for an obviously higher inflation rate is that households in emerging markets have higher food expenditure from their budgets which places a heavy weight on food demand, making it more inelastic. Another reason is that central banks in emerging markets such as Russia, China, India and Brasil, pursued an expansionary monetary policy in recent years. Money supply, for example, has grown tremendously. In Russia, for instance, money supply has grown by a swelling 42 percent and central bank's target interest rate (6,5 percent) is far below the official inflation rate (15 percent).

On the offset, rigid labor markets and inflexible wage determination lead to price-wage spiral. An evidence has been observed in Russia where wages are growing 30 percent annually, more than 3 times more than the growth of productivity. A combination of rigid and inflexible market mechanism and expansionary macroeconomic policy as well as supply shocks contributed to the rise in the inflation rate. Even though sound growth forecast, predict a fairly stable output growth rate in the medium term, central banks in emerging markets will have to face the fact that expansionary fiscal policy must be neutralized by a rise in the interest rates and a decrease in the growth of money supply as a neccessary measure to bring the inflation under control. Continued rapid growth in emerging markets means that relative-price shock will be temporary and the food prices will remain high. Also, exchange rate flexibility is needed to avoid intended currency depreciation which sets an important pressure on inflation expectations. Thus, without tighter monetary policy and flexibile labor markets, central banks may soon repeat the mistakes which caused the great inflation in 1970s.

Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK

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