[It is published in today’s Republica, p.6].
In the mid-term review of monetary policy, the central bank argued that inflation, which is a measure of the increase in general prices of goods and services over a period of time, target of 7 percent for this fiscal year won’t be met. Instead, it stated that inflation will be around 8 percent. Unsurprisingly, it is not the first time inflation target has been revised upward. The dynamics of the causes of price fluctuations in the economy has discombobulated Nepalese experts and policymakers for a long time. Given the unique yet evolving market integration between Nepal and India, the ineffectiveness of monetary tools to tame rising prices, and the increasing influence of oil prices on general price level, tackling inflation in Nepal would require both policy tools as well as earnest political commitment to correct market distortions.
Generally, inflation is determined by money supply in long term. In short term, it is determined by demand and supply pressures, which are in turn affected by the relative elasticity of wages, prices and interest rates. In Nepal’s case, monetary tools such as increase in interest rates and decrease in money supply have not been used specifically to control inflation because there is hardly any correlation between M2—a broad measure of money supply and a key indicator used to forecast inflation—and prices of goods and services. Instead, our prices have historically been following the prices in the Indian economy, thanks to the pegged exchange rate and free flow of goods and services across the open border. Furthermore, policy interventions (mostly fiscal tools such as taxes and expenditure) have been more or less consistent with changes in the Indian economy. Interestingly, this link has been weakening following the global food, commodities and fuel prices hike after 2007 for two main reasons: increasing imports of petroleum products and domestic market distortions. Policy makers preparing firepower to tame rising prices should take note of these evolving changes.
A recent study by the IMF economists showed that almost a third of the variability in domestic inflation can be attributed to the prices in India and movements of international oil prices. While food price increases contributed to about three-fourths of overall rise in price level, monetary factors mattered more for nonfood price inflation than for food price inflation. It indicates rampant domestic food market distortions and rise in domestic financing for imported durables. Overall, food prices have been more volatile than nonfood prices in the economy. The study found that the responsiveness of food price inflation was significant and quick to spillovers from India’s food prices and the global oil price fluctuations before 2007. However, after 2007 the impact of fluctuating oil prices is more persistent than the spillovers of food prices prevalent in the Indian economy. Even though petroleum prices do not change readily in our economy as they do in the international market, the price fluctuations are seen directly and indirectly in the cost of imported inputs (and final products) used by agricultural, industrial and service sectors.
These findings are not in line with an earlier held belief and research finding (including a 2007 study of similar nature by Edimon Ginting of the IMF) that inflation in India and inflation in Nepal tend to converge and the pass through of inflation from India to Nepal takes about seven months. With the changing composition of imports from India and the large share of petroleum products in import basket, this has been changing since 2007, thanks to increasing demand for fuel to power machines, generators and vehicles. Currently, the pass through time of food and nonfood prices from India to Nepal has shortened and international oil prices have greater impact than what it was thought to have before.
It is not that the prices are entirely determined by external factors. Domestic supply-side factors also matter, particularly market distortions. Note that when global food prices spiked in 2007 and 2010, being a net food importing country, domestic food prices also went up. But, when global food prices moderated, domestic prices did not normalize accordingly. Why did prices remain stubbornly sticky at high level? Well, it is because of supply-side factors such as strikes, hoarding, black marketeering, deliberate withholding of supplies and inventory, distortion of agriculture prices by middlemen, and agricultural trade hurdles imposed by our neighbors, among other factors. These have increased uncertainty and expectation of future rise in input cost. The inflationary expectation arising from the uncertainty over supply of fuel and cooking gas, its rising prices at global level, and supply-side constraints have primarily contributed to the series of food and nonfood price hikes in recent months. That said, prices are also pushed up by demand factors, especially consumption demand fuelled by high remittance inflows. However, consumption has been high (around 92 percent of GDP) for a long time, so it does not justify the stubbornly high and sticky prices.
The changing pattern of the impact of oil prices, inflation in India and the uncertainty over supply conditions have important policy implications. First, the policymakers need to factor in the volatile oil prices when they estimate targets for inflation rate as domestic prices are deviating from the prices in the Indian market. Second, monetary tools have little traction on inflation and inflationary expectation in the short term. Fiscal tools such as lowering levies on petroleum products and subsidizing inputs might help to moderate prices. However, these too have drawbacks as they tend to widen budget deficit, and confound policymakers in managing the tradeoff between taming high prices and maintaining fiscal space. Third, resolving supply-side constraints seems to be the most promising, yet most difficult, intervention to lower rising prices. Promising because it will correct markets and link production with demand, but difficult because it requires more political than policy action. Fourth, prices will continue to remain volatile and high unless the government reduces load-shedding hours and matches power generation with power demand. Else, people will continue to demand more fuel each year, which means more shortages as the government cannot procure enough of it because of its inability to supply adequate funds to NOC without a substantial increase in revenue generation and reduction in allotted expenditure for other sectors. Note that the import of petroleum products increased by around 50 percent last year and the total earning from merchandise export was Rs 10 billion short of the total value of petroleum import.
The evolving factors that are pushing food and nonfood prices up have to be well comprehended to better design macro policies aimed at reducing high inflation, which is eroding real purchasing power of people. Along with the prices in the Indian economy, international oil prices, and domestic supply-side constraints (including market distortions) are having strong bearing on inflation in Nepal. To bring down inflation back to the desired level, effective monetary and fiscal policies have to be formulated and enacted by considering these factors.
[Published in Republica, February 28, 2012, p.6]