Why Prices are Slow to Fall Despite Easing Interest Rates, Inflation

Originally appeared on The Morning

By Dhananath Fernando

Inflation is gradually easing to the 20% range and the Central Bank has made the decision to reduce the interest rates by 2.5%. Additionally, the Sri Lankan Rupee is appreciating. In regular news stories, the media and people often ask the question, “Why, then, are prices still high?”

How can we understand this through economics and determine what policies should be implemented to bring about maximum benefits for Sri Lankan citizens? Since everyone is a producer as well as a consumer, this affects all individuals.

Declining inflation doesn’t mean prices will drop

First, many hold the perception that inflation results in a direct increase in prices. The rate at which prices are rising, however, is what is actually known as inflation. It is the same as the acceleration of a vehicle; when we accelerate a vehicle, its speed increases. But once the vehicle is in motion, even without accelerating, it will move.

Declining inflation simply means that the speed at which prices are increasing has slowed down, but it does not mean that prices are actually decreasing. That is why inflation is considered the worst enemy of everyone, particularly the poor.

As Milton Friedman said: “Inflation is always a monetary phenomenon.” Another reason why we should not allow inflation to raise its head is because the remedial actions required to curb inflation come with their own costs and drawbacks.

To bring down inflation, interest rates must be increased. However, when interest rates increase, the economy shrinks, making the business environment more difficult to operate in. This is exactly what Sri Lanka is going through. When the business environment becomes difficult, social pressures tend to rise as well.

However, for certain essential items such as petroleum products, LP Gas, and some construction materials, prices have reduced due to currency appreciation. A common question, which is fair to raise, is how prices increase overnight when currency depreciates, but are very slow to adjust when currency appreciates.

When the media questions traders, a typical reason provided is that the stocks had been bought at a higher exchange rate, so the prices will be adjusted only with the next shipment. While there is some truth to this explanation, the absence of competition laws and a poor regulatory framework allows for price coordination and rent-seeking behaviour to also take place.

One reason for the lack of price coordination is the elimination of micro, small, and medium traders by government regulations themselves. If we recall the last few months, both the spot and forward markets were effectively not functioning due to Government regulations.

This prevented the opening of Letters of Credit (LCs) for a future date, based on the exchange rate at the time of reserving the USD. Additionally, there were regulations that stopped credit facilities for opening LCs. When banks do not provide credit facilities to open LCs, only large players who have the capacity to pay the full amount upfront are able to engage in the market.

Exchange rate appreciation and prices

This is precisely what happened in the case of sugar imports. When the forward exchange rate market was squashed, traders were unable to predict what the exchange rate would be by the time they had cleared the LCs at which point the imported sugar would have already been sold and the money collected.

Therefore, if the exchange rate depreciates significantly, the trader will incur a massive loss. While most of these regulations have now been reversed, many micro, small, and medium traders were wiped out from the market during the time these regulations were in place.

The limited players have made it easier for price coordination to occur to keep prices high even when the exchange rate strengthens. Similarly, the same circumstances were observed when price controls were imposed on poultry products. With price controls in place, layer chickens were sold out and it takes time for the market to reverse the effects. Sometimes, it is easier to just impose a quick regulation, but the recovery from that regulation can take years.

Regarding the exchange rate, until there is significant progress on debt restructuring, uncertainty remains. As a result, markets are reluctant to perform any adjustments. That is why, as a country, we need stable policies so that the business environment becomes favourable and even consumers do not have to worry about price fluctuations, as they will be adjusted in a systematic manner.

Price controls will not work

A common suggestion that is made to bring down prices is to impose price controls. People and the media are quick to jump on the decision to impose price controls, thinking it will bring the prices down.

However, it is important to understand that price controls do not necessarily lead to lower prices. Instead, they can have unintended consequences such as the emergence of black markets or complete shortages of goods.

We need to realise that the best-case scenario is to have both lower prices and sufficient availability of goods and services in the market. The second-best option would be to have goods available even at a higher price, as the non-availability of goods will cost consumers more in terms of finding alternatives for their needs. In such cases, the ultimate burden to the consumer is high due to the unavailability of goods.

That is why price controls are not a solution, as they do not effectively bring down prices and can create shortages.

The opinions expressed are the author’s own views. They may not necessarily reflect the views of the Advocata Institute or anyone affiliated with the institute.