Inflation Puzzle in Ethiopia

Single Digit Inflation Undesirable during Economic Takeoff

Source: addis fortune

Published On  Oct 30,  2011

by Eyob Tesfaye (PhD)

this article is written by Eyobe Tesfaye(PhD) under economic commentary page in addis fortune news paper and the whole idea of the article is solely to the writer.

Whilst the US economy teeters on the brink of a recession and many European economies are besieged by colossal public debt, several emerging and a few developing economies continue to enjoy robust growth.

Similar to other rapidly growing economies, the Ethiopian economy carries on to register vigorous Gross Domestic Product (GDP) growth. Although the growth performance remains exhilarating, the country’s economy remains in the grip of double digit inflation, currently standing at 40.1pc.

Apparently, the runaway inflation, together with the high inflation expectation, has become a serious predicament to the administration. Indeed, in early 2011, the country was able to achieve single digit inflation, leading everyone to believe that this nemesis was overcome.

Nevertheless, the inflation has once again resurfaced with a vengeance. The whole situation is reminiscent of a family that expressed gratitude for the survival of their home from a powerful hurricane but failed to prepare for more storms to come.

Inflation is an inevitable byproduct of economic growth, just like the increased exhaust emitted from a speedy car as it accelerates. As economies grow faster, it is inevitable for their engines to overheat.

The Ethiopian government has taken several policy and administrative measures to cool down the economy and keep a lid on the inflationary pressure. Despite these measures, inflation has refused to go away; its pressure has not yet been abated.

During his annual state of the union speech, President Girma Woldegiorgis indicated that fighting inflation will be the chief concern of the government in the 2011/12 fiscal year. He has vowed that the government will do everything possible to bring down inflation to a single digit soon.

Yet, whether it is possible to attain single digit inflation and there is a framework in place to attain it, it remains uncertain.

With inflation hovering and expectations remaining high, obtaining an easy answer to such a million dollar question is unimaginable.

Indeed, inflation provides an important insight on the state of the economy and the policies that govern it. Stable inflation provides impetus for economic growth. There is no doubt that stable prices are good for healthy economic growth.

There is no economic theory that states that an inflation rate of five per cent is better than one of 15pc. It is the structure of the economy that determines the threshold of healthy inflation.

Ethiopia has a chronically supply constrained economy with excess demand. Increasing government investment in infrastructure, rapidly growing private consumption, influx of foreign capital, and remittances have all exacerbated demand that outsprints supply at a haggle speed. Much of the resulting growth is gulled by real estate investment and property market.

Ethiopia's economy lacks financial depth and highly liquid marketable financial instruments. Domestic investment tends to get channeled into non-productive sectors over productive ones, which could have helped in correcting the imbalance between demand and supply. In a situation where there is a dearth of savings instruments to which people can turn, prices for consumer products tend to rise, creating ground for an inflationary spiral.

Addressing the demand and supply imbalance and spurring long-term growth requires vigorous infrastructure investment.

Infrastructure is a capital stock that provides public goods and services. It creates an environment for productive activities and allows wider movement of goods and people. It helps to commercialize and diversify the economy. Squeezing infrastructure spending to curb inflation does more harm than good to the economy.

Correcting the rise in food prices will also require structural changes in food production. This, on the other hand, requires increasing agricultural activities. Until meaningful and radical output increasing measures have taken root, it is hardly possible to head off inflationary expectations.

In the face of a chronic structural bottleneck and the need for increasing infrastructural investment activities, a single digit inflation target is neither attainable nor desirable. Curbing inflation must walk hand in hand with growth, as neither can walk alone to a useful end.

Instead of burdening itself with the task of achieving single digit inflation in a short span of time, the government would rather opt for moderate inflation ranging between 10pc and 15pc until the gap between demand and supply closes.