The Central Bank, tariffs and inflation

Deputy Director of the Master's Degree in Economics and Political Science at ESEADE.

CATO – In its latest monetary policy report, the Central Bank of the Argentine Republic recognizes that for 2021 there are some factors that generate pressure on inflation, among them, the need for an adjustment of public service rates. However, they maintain that this will not be a problem because the National Government “will coordinate forces” so that the decline in inflation continues.

Specifically, they argue:

Going forward, some factors could exert pressure on the price formation process, among which are: the recovery of the relative price of services, the advancement of joint agreements and the search for the recomposition of retail marketing margins in some sectors . However, it is expected that the coordination of these forces by the National Government with the different sectors of the economy will allow the gradual process of lowering inflation to continue.

To begin with, it is curious that the monetary policy report shows an almost zero role for precisely the monetary factors that determine inflation. Now, going to the point, it is worth wondering if it is the utility rates that generate inflation and, therefore, controlling this price is what will solve the problem of the fall in purchasing power.

Olivera Followers

The main point of this theory actually goes back to the work of a famous Argentine economist named Julio Hipólito Guillermo Olivera. In this article, from 1960, called The Non-Monetary Theory of Inflation, Olivera does not rule out that there are causes of inflation that are monetary (that an excess in the quantity of money leads to excess demand that increases prices) but states that this can also have its origin in the change of some specific prices in the economy.

In this sense, it is then going to say that if there are price inflexibilities, that is, prices cannot move much up or down, then the fact that a particular price changes by x%, since none of the other prices The economy will move in the opposite direction to compensate, then the price level will rise without the need for the quantity of money to increase.

If a concrete example serves to clarify, suppose that the kilo of oranges is in $ 100, while the kilo of bananas is obtained at $ 200. In that economy of two goods, the price level is $ 150 (an average of both individual prices). Now, if oranges go up to $ 200 and, at the same time, bananas don’t go down, then the average price level will have risen to $ 200. Olivera’s thesis is that this can happen without increasing the amount of money.

This idea is what the Central Bank takes today to detach itself from the responsibility for inflation and place it on what the National Government can do with public service rates and other prices or rates of the economy.

First inflation, then the “rate”

One problem with this theory is that, first, and in the specific case of tariffs, inflation comes first, and then the need to adjust them.

During the first three Kirchner administrations, the combination of high levels of inflation with the freezing of public services resulted in residential electricity rates falling 80% in real terms. Now electricity rates have been frozen since March 2019, while gas rates were frozen in April.

In the same period, the general price level accumulated an increase of 75% and 69% respectively.

Faced with these scenarios, the government has two options: either maintain the freeze in the hope that inflation will not rise – beyond the fact that it does rise despite the controls – or decides (gradually or suddenly) to honest prices , recognizing that they were “behind” with respect to inflation.

Now, if you take this second path, it is because inflation led to the need to adjust rates, not that the rate unfreeze has generated inflation. First comes the monetary issue, then prices rise, and finally the prices that the government did not allow to rise before.

Short term vs. long

A more fundamental objection to the non-monetary theory of inflation is that it confuses a short-run phenomenon with a long-run explanation for the inflation issue.

It is absolutely probable that if tomorrow the utility rates rise 50%, when the INDEC does its price survey it will notice that one of the prices in the basket with which it calculates inflation will have risen. At the same time, in the very short term, the rest of the prices may remain unchanged since the reallocation of consumption by the agents will not occur immediately.

however, in a longer term, and as long as the government does not increase the amounts of money further, then this general increase in the price level will not be validated. Over time other prices in the economy will have to fall because there simply won’t be money to pay for them.

Going back to the example of oranges and bananas, if the total amount of money was $ 300, then only in the short term can both oranges and bananas have a price of $ 200. In the long term, the price will rise of a kilo of oranges will be made at the cost of the drop in the price of a kilo of bananas, keeping the price level constant.

Obviously, it can also happen that whoever produces bananas cannot reduce their prices without closing the business. In this case, the adjustment in the price of oranges will result in an economic recession. In the case of rates, the same thing happens. As consumers will have to spend more on energy, we will have less to spend on bakeries, so if their prices cannot go down, some will close their doors, generating an economic contraction.

But the costs of this short-term honesty must be compared with the costs of destroying the national energy system, which is the only corollary that will arise from maintaining the policy of price controls on the sector.

Do not repeat the past

In order to close, it is true that in the short term the adjustments of some regulated prices generate an upward impact on the price index. But inflation as a long-term phenomenon is not caused by these adjustments, it is the cause of them. Furthermore, in the long term, regardless of the rates that have to be made, if monetary policy is under control, inflation will fall, as it has in all the countries of the region in the last 30 years.

In Argentina long before both the Cristina Kirchner and Mauricio Macri governments began to adjust public service rates, inflation had multiplied by 10, going from about 3% in 2003 to about 40% in 2014. If we are not willing to learn from the lessons of the past, we are doomed to repeat it.

This article was originally published on Iván Carrino’s personal site on December 6, 2020.