Inflation has adverse effects on many sectors. It decreases the purchasing power of people by eroding their real income. High inflation distorts price relatives, creates uncertainty and discourages savings, investment and consumption. Although everyone feels the pinch of inflation, it has a worsening impact on fixed income groups and the vulnerable. Low-income households depend on wages, pensions and social security as their major sources of income. Such income responds less to inflation. On the other hand, a majority of their income goes for consumption which has currently been hit hard by increased food prices. Thus, inflation has been labelled as the worst tax on the poor. So, policymakers always try to maintain a low and stable inflation rate. Such an environment is known as price stability, a situation where the overall average of prices is stable even though prices of individual goods and services may rise or fall.

Price stability preserves the purchasing power of money. Furthermore, it helps the market economy function smoothly, allowing economic agents including households and firms to make consumption and investment decisions without worrying about fluctuations in the general price level. Obviously, this enables better decision making by economic agents, leading to more stable investment, output and employment. Price stability helps to anchor inflation expectations of the common people. Many studies have concluded that price stability helps promote general stability and efficiency of the financial system. Ultimately, price stability is a condition for macro economic stability and sustainable economic growth of the nation. Price stability is also important for reducing poverty and inequality. Almost all central banks of the world have the objective of maintaining price stability in their charter. The central bank attempts to maintain price stability through its monetary policy. The government can also combat rising inflation through fiscal measures.

Inflation rising

The low and stable inflation that we used to enjoy in the last few years is now a thing of the past. Inflation is soaring around the world. According to one projection from the International Monetary Fund (IMF), about 77 percent of countries reported acceleration in inflation in 2021, and this proportion is expected to rise further to 90 percent in 2022. In this way, inflation has become global. Reports indicate a few reasons behind this. The first is supply chain bottleneck. The coronavirus pandemic which came in successive waves disrupted the global supply chain with transportation of raw materials and intermediate goods being severely affected. The second reason is that global demand for durable goods surged in comparison with demand for services.

The third reason is that almost all governments announced economic stimulus packages for fast recovery of the economy. According to the IMF, about $16.9 trillion in fiscal support was announced globally to fight the pandemic. Obviously, such stimulus not only contributed to post-pandemic recovery, but also led a surge in aggregate demand. Fourth, the prolonged war between Russia and Ukraine—two exporters of major commodities—also contributed to rising energy and food prices. Finally, labour market disruptions from the pandemic also contributed to inflationary pressure in many countries. These factors, on the one hand, boosted aggregate demand, but on the other hand, squeezed aggregate supply resulting in higher inflation.

Nepali context

According to the current macro economic statistics of Nepal published by Nepal Rastra Bank, year-on-year inflation for the month of May-June 2022 has elevated to 8.56 percent. Food prices have shot up in the market. The prices of various services like transportation, education, health, housing, utilities and recreation have also picked up. In some cases, consumers are experiencing the case of shrinkflation, where firms are making product packets smaller instead of raising prices. There are various reasons behind spiking inflation in Nepal. The first is lack of a robust domestic production capacity. We have become a commodity importing nation, and global inflation easily passes on to us.

Second, the war in Ukraine has pushed up the prices of edible oil and petroleum products. This increased raw material prices and transportation costs, which elevated the production cost of domestic firms. Third, during the previous fiscal years, there was rapid credit expansion. This helped to fuel real estate and asset prices which ultimately increased aggregate demand in the economy. Another reason is the base effect. When we measure the current inflation rate, we are also measuring inflation of the previous year. The annual average inflation rate of the last fiscal year was a meagre 3.60 percent. Obviously, such a low base is also one of the reasons for a higher inflation rate.

The days to come are likely to be tougher. Our increasing over-reliance on imports for even basic commodities like rice, fruits and vegetables is a reason for worry. Meanwhile, many countries, including our neighbour India, have used trade restrictions and export bans to protect domestic supplies of food. The Ukraine-Russia war and increasing oil prices in the global market is likely to put further pressure on inflation in the near future. The annual budget for the current fiscal year has incorporated provisions like a salary hike for civil servants, increase in social safety allowances and other distributive natured programmes. Surely, this will add to inflationary pressure in more ways than one, and the depreciation of the Nepali rupee against the United States dollar will also cause imported goods to be dearer in the days to come.

In such a situation, taming inflation with the aim of safeguarding the economy and preserving financial stability should be on the priority list of all stakeholders. Banks and financial institutions should follow prudent practices and issue credit to increase domestic production. On the other hand, the government should adhere to fiscal discipline. Instead of focusing merely on quantitative restrictions, the government should not hesitate to raise tax rates and custom duties to manage demand for luxury goods. Enhancing domestic production, implementing work plans related to reducing consumption of petroleum products, and structural reforms along with other fiscal measures to smoothen supply chain are also the need of the hour. Administrative measures to control black market-related activities are also necessary to control inflation.

The onus is on Nepal Rastra Bank to tame inflation from the demand side. The central bank has taken strong steps in this direction through the recently unveiled monetary policy for the current fiscal year, which includes a hike in the policy rate along with measures to control credit expansion. However, we should be aware that monetary policy alone is not sufficient to maintain price stability, and monetary policy cannot be carried out in isolation from other macro economic policies. Thus, we need a strong impetus for close coordination and cooperation among all stakeholders to bring inflation back on track.