Inflation isn’t always bad. But we should still be worried 

Simply put, inflation is a part of the business cycle. The business cycle refers to regular but alternating periods of economic booms and slumps because of the natural interaction of economic forces like demand, supply, employment, price, etc.

Periods of economic boom are characterised by high aggregate demand and increased production and employment. In response to higher aggregate demand, in the absence of intervention by the government or other external forces, prices would have to rise – resulting in inflation. 

As inflation continues to rise, the demand and thereby production levels drop and firms lay off excess labour to balance their accounts, leading to an economic slump. The subsequent fall in demand causes prices to adjust downward and demand rises again and this cycle continues. 

Inflation is merely an indicator of economic growth and not the other way around. What about inflation should have us worried then? 

Primarily, inflation erodes the purchasing power of the citizens, particularly the most vulnerable communities in society, i.e., the lower and lower-middle class, as they are disproportionately more affected by the inflationary pressure. 

Then when the rise in price level is not accompanied by a proportionate rise in the nominal wage or when the real wage [wage adjusted for inflation] falls, inflation becomes a cause for concern. For instance, if the cost of purchasing a standard consumer basket rises by 5%, then the nominal wage of workers must rise by at least 5%. If not, inflation – regardless of being an indicator of economic growth – will severely impact the less fortunate. 

Dr Zahid Hussein, Former Lead Economist at the World Bank, said, "According to a recent study by the Brac Institute of Governance and Development, the earnings of the low-income individuals in Bangladesh were increasing till January thanks to the post-pandemic economic recovery. 

But with rising consumer demand and the Russia-Ukraine war, prices soared and rising inflation wiped 6% of their income, leading to a livelihood crisis. The survey found that the low-income groups were spending less on food and education because of decreased purchasing power. That is, a country should worry about inflation when it leads to inequality and poverty." 

Secondly, inflation becomes a concerning issue when it disrupts the financial market and thereby the investment climate in a country. The rational consumer deposits their savings in the capital market based on the comparative benefits from the deposit rate against inflation. If the rate of inflation exceeds the deposit rate, individuals no longer have the incentive to save as they are better off investing in more profitable ventures.

Inflation can become particularly uncertain for the capital market if the interest rates are fixed at a predetermined level, as is the case in Bangladesh. 

Firstly, even when the inflation rate exceeds the deposit rate, the central bank remains reluctant to adjust – reducing the saving incentives of the public. On the other hand, if it raises the deposit rate, it will have to raise the borrowing rate to keep the banks profitable.

But a higher borrowing rate, especially in a post-pandemic economic landscape, might hurt small businesses and discourage them from taking out loans from formal channels and even hiring new workers. 

For example, in the US, the Federal Reserve aims to bring down the inflation rate from 9.2% (in June 2022) to 2% in the coming months. Doing so would require significant structuring of the federal-funds rate and may lead to an economic recession. 

When asked about the role of inflation in the Bangladesh financial market, Dr Zahid said, "Ideally, the deposit rate for each month should be equal to the average inflation rate of the past three months. Based on the last three months, the deposit rate should be around 6.5-7%.

But there are two problems. On one hand, that may still not encourage depositors to save in financial institutions as investing in 10-year-long savings certificates will earn you an 8% interest rate. On the other hand, the lending rate is fixed at 9%. Raising it will affect small firms and not raising it may make banks lose profitability. Overall, it's a messy situation."