“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair”. Sam Ewing.
Credit for the title of today’s treatise goes to Professor Milton Friedman(1912-2006). The 1978 Economics Nobel Laureate belonged to the Chicago School Of Economists who came up strongly against the theories of John Maynard Keynes and advocated for minimal government intervention and subsequently developed the economic theory known as Monetarism. Monetarism posits that money supply is the most important driver of economic growth. Accordingly, as money supply increases, people tend to demand more. Consequently, factories produce more, thus creating new jobs. A major drawback to monetarism, however, surfaced with the global recession in 2001 when it became apparent that liquidity which includes credit, cash, and money market instruments are not necessarily measured by Central banks.
For the ordinary man on the street, inflation is what occurs when the money in his pocket fetches less goods than it previously did. More money therefore begins to chase fewer goods. In the satirical description of the effect of inflation on a salaried worker, it is the situation in which at first there is so much money left at the end of the month and later, there is so much month left at the end of the money!
In technical terms, inflation is a quantitative representation of the upward direction of general price level of goods and services over a certain period of time. It is a relative number that speaks to the price level between one date and another. It is a key economic indicator, the strategic nature of which is bellied in the underlying factors that drive its outcomes. The idea of average price level implies that a select basket of goods and services will be tracked and measured. To have a fair representation therefore, the selected goods and services whose prices are tracked over a specific period, must be representative of what people typically spend on, every day. Price level could go up or come down. When it goes up it is said to be inflationary but when it comes down it is deflationary. Inflation, therefore does not only affect the prices of things in the market but also purchasing power, because if income remains the same in an inflationary environment, you are able to buy less over time as things get more expensive. The question though is: what drives inflation? There are basically three factors that drive inflation and these are generally stated as follows:The first is when the demand for specific goods and services increases faster than the production capacity of such goods in the economy. The goods and services thus become scarcer and consumers will be willing to pay more to have them. This creates a demand-supply gap that pushes prices higher. This situation will also happen when there is increased money supply to individuals in the system that is not supported by economic value. Also, an increase in the money supply by the monetary authorities increases the consumption capacity of the population, which will create a scenario where people spend more from more money in their possession resulting in price increases. While these can be the result of a natural economic occurrence, it could also be artificial. A good example was during the Udoji Award of 1974, when there was a sharp increase in the salaries of workers. This led to huge demand for certain types of goods and a consequent increase in their prices. If a cartel, like OPEC decides to cut production of crude into the market, prices are likely to go up for crude and therefore petroleum product, pushing prices up. This phenomenon arises from artificial factors. However, increases in demand for energy as a result of economic growth or weather condition would result in a demand pull that will definitely push prices up.
Increase in the prices of the cost of production could also push prices up. In Nigeria where a lot of our manufacturing inputs are imported, a devaluation of the local currency is a major contributor to a cost increase that will result in increase in the price of finished goods. Still on this, if for some reason, the average price level goes up in the country from where we import finished goods or inputs, we are bound to import that inflationary pressure into our domestic economy and transfer the consequences to final consumers. In fact, it is for this reason that countries that meet a large proportion of their needs through local sources do not worry so much about exchange rates. Indeed, for a country like China where they produce for export, the devaluation of the Yuan makes such exports cheaper to the foreign buyers and thus they become competitive relative to others. This is actually one of the major issues of conflict between the USA and China. The former believes that through currency manipulation in which the latter’s currency is deliberately weakened, such goods sold in Yuan become preferred.
Inadequate or deteriorating infrastructure, whether it is power, logistics, storage or other facilities, tends to push production costs up as well as increasing risks and therefore risk mitigating expenditures that naturally increase cost of goods and services. Also, demand for specific inputs as described above may increase faster than its production rate; other cost increases like raw materials will generally contribute to increases in costs. In Nigeria today, it is said that the scourge of inadequate power supply adds about 40 per cent to the cost of production.
A third driver of inflation could be collectively referred to as those costs that tend to increase as a result of expectations resulting from inflationary forces themselves. This will relate largely to the cost of living and reduction in purchasing power arising from a general increase in the cost of living that then calls for a lift in living wages thus increasing costs of production and cost of finished goods. Agitations by labour groups for salary increases and the improvement in minimum wages, which is imminent in Nigeria, are just some of those factors that may fuel inflationary pressure.
It should be observed that all the factors driving inflation seem to be related and interactive as one driver tends to induce another. This is why inflation needs to be managed by experts as it has the potential to spiral and become a vicious cycle. It is usually the objective by respective economic managers in different jurisdictions to manage inflation by moderating it rather than eliminating it. Every economy experiences inflationary pressures from time to time, and a little bit of it could arguably be said to be good for any economy. Economic theory allows a tolerable inflation rate of between 2 to 3% per annum, for the economy. This theory insists that it is necessary for growth and equilibrium employment level. However, when the rates begin to burst those limits, the managers of the economy should have cause to worry.
While inflation is natural to economic activities, it is the manner in which it is managed that delivers a great or bad outcome in business and the economy in general. If we agree that businesses are all about prices and how they are managed, and that prices are at the core of whether businesses do well by making a profit or not, then it will be a great idea to discuss a bit as to how businesses should respond to inflation. The question is that if I know that prices will go up by an inflation rate in a year’s time, how should I set my price today. If for example my cost of production is N10,000 and I intend to sell at a profit of 20% it means I would sell for N12,000 at today’s prices. If inflation rate is, however, 10% it would mean the cost at which I can produce the same item next year will be N11,000, meaning that my effective profit will be N1,000 instead of N2,000. Effectively therefore, even though I have planned a profit margin of 20%, my real margin is 10%, after factoring in the effect of inflation. I have, of course assumed that demand and other possible variables, are held constant.
Inflation tends to force investment and define a hurdle rate for returns on investments and savings. Returns must exceed, at the minimum, the inflation rate in the economy. Otherwise, you will have a negative return on your investment. It also shows that holding cash except for the purpose of managing risks associated with meeting liquidity requirements of the business, is undesirable as cash holding, definitely will lose its purchasing power. It should also be realized that price is also used as a means for managing household behavior and the economy generally. When prices are high, household consumption of goods and services will be restrained and when prices are low consumption tends to escalate. If this is not well managed it could induce more inflation as demand for goods tend to grow faster than production, pushing up prices again, even if momentarily. If well managed, it could stimulate economic activities and support production and growth. Maintaining a dynamic balance will always be the answer. It is also important to point out that inflation is a constant feature in every capitalist system as it is one of the key factors that encourage investment and business.
One thing that is always undesirable, however, is the very high and unstable inflation rates due to its negative impact on the economy. It brings uncertainty to economic and business projections and planning, thereby increasing risk and reducing the attractiveness for further investment. It will not be out of place to evaluate the Nigerian situation and how our culture and systems respond to some of these global principles:
This is a major input into the basket of cost that fuels inflation. Even though the cost of input materials has increased greatly due to the local currency value, vis a vis the dollar, cost of operations, and financing cost, the federal government through the regulatory agency the Nigerian Energy Regulation Commission, NERC, has been unable to approve increased prices in line with MYTO (Multi-Year Tariff Order). Generally, we have also not learnt to moderate our use of energy in an efficient manner. Unlike in other economies, citizens are not very sensitive to their energy consumption to control their cost. We leave our air conditioners on and go to work. We leave lights on in rooms that are unoccupied. The whole idea of energy conservation is lost on us. Clearly this behavior frustrates investment in the sector. We can argue all we like about meter and the non-availability of power, if price is uneconomic, it is difficult to make the required investments that will change the situation (a discussion for another day though).
It was argued earlier that when prices go up behavior is moderated. We have witnessed the prices of petroleum products go up mostly and seldom, down, yet we continue to use our cars at the same levels. We drive the cars to the super market next door and put no pressure on our government for an efficient public transport system. It was the Mayor of Bogota, Penalosa that said, “An advanced city is not one where even the poor use cars, but rather one where even the rich use public transportation”. This thinking is alien to us in Nigeria. Even the idea of carpooling or ride sharing to conserve energy and save cost is strange to us. Here, like in the case of power, whether the prices go up or come down, the price to us remains the same. We have therefore lost the efficiencies and discipline that price brings.
Cost of Capital
Lending rate or the price at which corporations and individuals borrow from banks, is a key stimulator for economic growth. Financing is a common denominator to every growing enterprise. If the cost of credit goes down, the viability of several projects and profitability of several companies can be taken for granted. Mortgage loans, for example are unsustainable at double digit interest rates, which is not uncommon in Nigeria. These rates technically mean that the cost of a typical piece of property theoretically doubles every five to six years. In what world is this a sustainable proposition? I admit that there are many factors that add to the cost of credit for banks, but inflation is one of them and a major one at that. However, it would appear that although inflation rate came down from 18.7% in 2017 to 11.44% in 2018 it made no difference to the lending rate which continued at an average of 24%pa. Matters have also not been helped by the Monetary Policy Rate which has remained at 14% for the last few years. What this means is that in the Nigerian economy, there is no relationship between interest rates and inflation rate. A reduction in MPR would at least show a clear signal of the direction lending rates should go while at the same time discouraging banks from holding their excess funds in government securities and other risk free instruments. The private sector has, therefore continued to groan under the very high cost of credit in Nigeria that seems to hold out irrespective of where inflation goes.
The point is that as a people we are yet to understand the phenomenon of inflation and how we can use it to our collective and individual advantage. We continue to lose the opportunity to make adjustments to our pricing regime for some key commodities. We seem unresponsive to inflation trends and there is no conservation, no response, no reallocation of resources or change in behavior, regardless of which way inflation goes. Elsewhere, it is seen as a monster that must be caged. The 40th American President, Ronald Reagan regarded unchecked inflation is as being “violent as a mugger, as frightening as an armed robber and as deadly as a hit man”.