November 10, 2007

INFLATION AND THE EFFECTS ON THE FINANCIAL SECTOR
by CIB Risk & Research Department

Introduction

Following this country’s general elections on November 05, 2007, one of the most critical policy issues facing Trinidad and Tobago is inflation. Inflation is a sustained increase in the general level of prices. Inflation is a monetary phenomenon that occurs when the quantity of money in circulation rises faster than the stock of goods and services available. The inflation rate is normally measured by percentage changes in the cost of a basket of consumer goods and services. In Trinidad and Tobago, the retail price index is the indicator used to measure inflation.

Generally, the cause of inflation can be explained by either demand-pull factors and /or cost push factors. Demand pull inflation relates to the adage “too much money chasing too few goods”. It is normally associated with money creation which, in most cases, comes from the monetization of a fiscal deficit. Cost-push inflation relates to the increases in prices of key inputs such as electricity, gas, and oil to name a few, which is passed on to the consumer through higher prices of the final product. Additionally, it could result from the devaluation of the currency which increases the prices of imported inputs in domestic currency terms.

Inflationary Environment

In the local economy, the rapid rate of economic growth and the high level of government expenditures over the last three years, in the context of declining spare capacity resulted in a sharp rise in inflationary pressures. The most recent inflation data released by the Central Statistical Office indicate that the rate of inflation has fallen from a high of 10% (October 2006) to 7.9% as at August 2007.

Notwithstanding the fall in the rate, the populace is still being faced with high prices, which increased significantly over the last two years, on average by 27.4% per year. The price of food was a major contributor to the creation of inflationary pressures within the economy. In addition to food prices and wages, credit to the private sector and government expenditure were also contributors to inflation. The current stickiness of core inflation suggests that underlying inflationary pressures in the form of fiscal and monetary impulses are quite strong.

Looking at the inflation rate over the last 30 years, from 1975, the inflation rate has averaged in excess of 12% in the first two - five year periods. The second lowest rate of 4.8% was experienced in the last five years. The upward trend of the inflation rate is consistent with the general trend in many hydrocarbon-exporting countries, for example Nigeria and neighboring Venezuela. However, in comparison to some of our major trading partners, such as the USA and Caricom, inflation is running ahead.

In an effort to curb this trend, the Central Bank of Trinidad and Tobago has implemented an aggressive liquidity absorption policy. This policy enables the Central Bank to utilize open market operations to control the supply of money and thereby prevent inflationary trends. However, the Central Bank’s policy actions have had varying levels of success in curbing this trend. Due to the Central Bank’s inability to effectively curb inflation through the use of its REPO rate, which was not permeating through the other interest rates, the Central Bank resorted to less market driven measures; requiring that commercial banks make two one-time special deposits of about TT$ 1 billion and creating a secondary reserve requirement (2% of liabilities). The Bank has maintained the REPO rate at 8% since September 2006.

Inflation and its implications on the Financial System

Inflation adversely affects various sectors of the economy, prompting those affected to seek to protect the real value of their incomes. Inflation affects the purchasing power of money, hence reducing the quantity of goods that can be purchased with a given amount of money. More importantly, increases in inflation not only reduce the real rate of return on money, but it also drives downward the real rate of return on assets in general, since investors would tend to shift from financial assets into real assets. Theoretical insights into inflation suggest that inflation exacerbates frictions in the credit market by reducing the overall amount of credit available to businesses. This is critical to developing countries such as Trinidad and Tobago since high inflation can decrease the real rate of return on assets causing a disincentive to saving, while encouraging borrowing for speculation. As a result, the banking sector tends to make fewer loans, resource allocation is less efficient, and intermediary activity diminishes with adverse implications for capital investment. Empirical evidence has shown that financial sector development is strongly linked with long-run economic performance. Hence, the reduction in capital formation can negatively influence long run economic performance of the country.

To facilitate the increased demand for credit that usually occurs during periods of rising inflation, commercial banks tend to price loans higher to compensate for the declining real returns. This results in a widening of the interest rate spreads and a crowding out of less risky but productive investment projects. The widening interest rate spreads can be of great advantage to commercial banks, by increasing their net interest income. However, it can also give rise to higher levels of delinquency, which is a cost to the banks.

Inflation also affects investment and savings decisions as it adds greater uncertainty to the future and hence complicates strategic planning. It hurts people who are retired and living on a fixed income, since their purchasing power is diminished. This discourages savings because the money is worth more today than in the future. This expectation reduces economic growth because the economy needs a certain level of savings to sustain capital investment.

In conclusion, high inflation not only disrupts the operation of a nation's financial institutions and markets, it also discourages its integration with the rest of the world’s markets. Inflation causes uncertainty about future prices, interest rates, and exchange rates, and this in turn increases the risks faced by potential trading partners, ultimately discouraging trade.