Grappling with inflation

Aunindyo Chakravarty
Senior Economic Analyst

INFLATION is a political hot potato. Governments fear it like the plague and one of their key aims is to ensure that food prices remain stable. The working classes are the worst affected by it. If prices of essentials go up, they are forced to cut back on other ‘discretionary’ spending. They buy fewer clothes, they stop buying hair-oil or shampoo, switch from toothpaste to tooth powder, or they downgrade to cheaper brands and smaller packs. India’s FMCG companies are already complaining that high food prices have made it difficult for them to sell their products in rural India.

Inflation targeting is a way to increase returns for finance capital and has very little to do with protecting the poor.

But what if someone’s earnings grow at a faster pace than inflation? Would they care about the increase in prices? The answer is no. A few years ago, when I was a full-time news professional and earned a very handsome salary, I didn’t care how much things cost. This was because my family’s ‘essentials’ budget was a very small part of my total income. Even a 10 per cent increase in prices didn’t make much of a dent to my ability to spend. I would put things in my shopping cart without looking at their price, and I never checked the final bill to see what cost how much. Old habits die hard, but my profligacy has been significantly tempered by the sharp drop in my earnings, now that I am self-employed.

This suggests that inflation can only be seen in relation to incomes. If incomes are high and growing at a fast pace, inflation is of little consequence. So, the best way for governments to counter the political consequences of inflation is to create a policy environment that boosts people’s incomes. You could argue that such a move will only make inflation worse: If people have more money in their hands, they will want to buy more goods and services. Demand will grow and fast outstrip supply, pushing up prices. And that will put us back into an inflationary spiral that will soon run out of control.

This is simply not true for a country like India – or any current economy, for that matter. Indian factories can produce much more than they currently do. If they have 10 machines installed, right now they are only using seven. They can easily increase their output by 40 per cent before there’s even a whiff of a shortage of supply. As they run more of the idle machines, their cost per unit of output goes down. That means, if demand increases, companies should be able to increase their capacity utilisation, lower their average costs, and make more profits, even if they sell their products at the same price.

An initial government-induced, spurt in demand will encourage businesses to increase production, as they get fresh demand signals from the market. They will employ more people, which, in turn, will end up increasing the total pool of wages to be spent on buying goods and services. This is a virtuous cycle of demand creating supply, creating demand. As capacity utilisation reduces, the per unit cost of goods, increasing profit-margins, there will be more funds available for future investments. Businesses will then buy more machines, establish new factories and offices anticipating future demand. With a small lag, this will create more supply. So, increased employment and growing earnings is the only antidote to long-term inflation.

Yet, governments react to inflation by reducing employment. How do they do that? By reducing fiscal deficits, increasing interest rates and tightening money supply. Thanks to the monetarist dogma, introduced in the US by Reaganomics in the early 1980s, and spread to the rest of the world through the Bretton Woods institutions in the 1990s, governments and central banks across the world react to high inflation with tight-money policies. The logic behind this is that excess money supply has resulted in artificial demand that cannot be met by current state of supply, so demand must be cooled off by reducing the money supply. Cutting interest rates will reduce credit-fuelled consumption, whether it is final consumption by households or productive consumption by industries. This will also reduce wages and employment and push down overall demand, reducing inflation.

There is another side of the same coin – to tame inflation by reducing employment. It is argued that when economies achieve full employment, businesses are unable to grow without paying much higher wages. That pushes up their costs, which, in turn, shows up in higher prices of goods and services. Also, as wages go up, workers have more money to buy things. Demand goes up at a faster pace than supply, and this again causes high inflation. While these two arguments come from two opposite camps within mainstream economics, they both bet on cutting back on employment and wages to cool down inflation.

Logically, this should be a problem for the corporate world, because lower output, and a higher cost of capital affects capital accumulation. Yet, corporates universally support inflation-targeting by central banks. This is because, since the 1980s, the capitalist world has been dominated by finance. Inflation reduces the value of financial assets and eats into returns on speculative capital. That is why finance capital must always guard against inflation, even at the expense of corporate capital accumulation.

One might argue that stock prices could go down if investors feel that a company’s business is not going to expand. However, in reality, stock prices usually track immediate earnings and fund flows, rather than the long-term growth of a company. In the immediate future, a drop in the wage bill and input costs helps companies expand their profit margins. We saw that happen during the Covid lockdown, when India Inc posted record profits despite a drop in overall sales numbers.

Inflation targeting is a way to increase returns for finance capital. It has very little to do with protecting the poor from a higher cost of living. After all, no worker would trade their jobs for lower prices.