Image Courtesy – Development Asia

Sri Lanka’s year-on-year inflation, which was on the decline since September 2023 saw an abrupt uptick in January 2024 (Link 01). The announcement of the rise in inflation falls contrary to the general expectations of tighter monetary policy and austerity.

Following is a direct extract from the announcement.

“Comparing the month-on-month changes, NCPI (Base 2021=100) in January 2024 has increased to 215.0 from 208.8 reported in December 2023. This shows an increase of 6.2 index points or 2.93 percent as compared to
December 2023. The month-on-month change was contributed by increases in food items and non-food items of 1.17% and 1.76% respectively.”

(Link 02)

What’s the reason for a rise in inflation?

The traditional Phillips curve(explained in Link 03), which illustrates the inverse relationship between inflation and unemployment, assumes a quick adjustment of wages to changes in economic conditions. However, in reality, wages often exhibit stickiness and may not adjust promptly to changes in monetary policy. If wages remain inflexible, the expected reduction in inflation through tighter monetary policy may be delayed or attenuated.

However, Sri Lanka’s situation is unique, with no changes to wages, hikes in taxes, hikes in prices and a massive contraction in consumption a fundamental breakdown of the production of the country has been occurring for a long time. Mainstream economics will not be able to explain the rise in inflation even during a time where textbook techniques to reduce inflation are in full swing.

The intricate web of the modern globalized economy has ushered in an era where nations are profoundly interconnected through intricate and far-reaching supply chains. This complex interdependence presents a nuanced challenge for domestic monetary policies, as their influence on prices becomes constrained, particularly in the face of inflationary pressures that emanate from global dynamics, including supply chain disruptions, commodity price shocks, and geopolitical events.

Supply chains, once primarily localized, now stretch across borders, encompassing numerous countries in the production process of goods and services. As a result, disruptions at any point along these global supply chains can have cascading effects, causing shortages, delays, and increased costs. When such disruptions occur, the traditional tools of domestic monetary policy, such as interest rate adjustments, may offer limited efficacy in addressing the ensuing inflationary pressures.

Commodity price shocks, driven by factors like fluctuations in global demand, geopolitical tensions, or supply constraints, have the potential to transmit inflationary impulses across national boundaries. In a globally integrated economy, where countries heavily rely on imported goods and raw materials, changes in commodity prices can swiftly impact domestic inflation rates. Monetary policy responses within national borders may struggle to counteract the broader economic consequences of these external shocks.

Geopolitical events, such as trade tensions, conflicts, or sanctions, can significantly influence the global economic landscape. The repercussions of such events may reverberate through supply chains, disrupting the production and distribution of goods and services. In these instances, the effectiveness of domestic monetary policy in quelling inflation is diminished, as these external forces exert substantial pressure on prices that transcends the scope of national economic levers.

Tightening monetary policy, which typically involves measures like raising interest rates to curb inflation, may prove insufficient in the face of these external drivers. The interconnected nature of the global economy implies that inflationary forces originating beyond national borders can permeate domestic markets, rendering conventional policy tools less effective. Policymakers are compelled to consider a more comprehensive and coordinated approach, incorporating not only domestic monetary measures but also international cooperation and strategic policy coordination to navigate the complexities of a globally integrated economic landscape.

In essence, the challenge lies in recognizing that inflation in the modern era is not solely a reflection of domestic economic conditions but is increasingly shaped by a myriad of global factors. As nations grapple with the intricacies of a world knit together by complex supply chains, the limitations of relying solely on domestic monetary policy become increasingly apparent in the face of external drivers that transcend national boundaries.

Why does a story on higher inflation not capture headlines?

There are more examples of when austerity has failed as opposed to when it has worked. The term “austerity” indicates a policy of sizeable reduction of government deficits and stabilization of government debt achieved by means of spending cuts, tax increases, or in the case of Sri Lanka, both. This approach is guaranteed to have damaging consequences as is the case with any position where blind trust is used. But is it working in Sri Lanka?

Even on mainstream search engines, the first few results (when searched for “Critique of IMF Monetary Policy”) are generally in favor of austerity, taking a pro-IMF stance, with most of it being presented from the IMF official website itself. Though search engine optimization plays a role in this, it is clear on the detailed observation that there is difficulty in finding critical content on the IMF. The impact of this has been on unsuspecting developing countries such as Sri Lanka.

Link 01-https://www.cbsl.gov.lk/en/economic-and-statistical-charts/inflation

Link 02- https://statistics.gov.lk/InflationAndPrices/StaticalInformation/MonthlyNCPI/NCPI_January_2024

Link 03 – https://www.investopedia.com/terms/p/phillipscurve.asp#:~:text=The%20Phillips%20curve%20is%20an,more%20jobs%20and%20less%20unemployment.