Since the sharp pick up in inflation in the latter half of 2007, there has been a great deal of talk about the causes of the increases in the cost of living and much debate about the solution to the problem. Many commentators have pointed to the sharp rise in the price of oil and the steep increases in the price of food staples on the world market as the main factors behind the higher local inflation.

However, this explanation is not altogether satisfactory as there are many other countries in our region of the world whose economies have been subject to the same international price pressures as ours but whose inflation rates are in the low to medium single-digit range while ours is in the high teens. There may therefore be local factors which have been responsible for a good deal of the inflation that we are currently experiencing.

Money supply and inflation

Economists tell us that inflation is highly influenced by monetary policy and is very strongly related to the rate of growth of the money supply. It should therefore be no surprise that the rate of growth of M2, the broad measure of money supply, grew steadily throughout 2007, peaking at 22% per annum in October, before falling back to 17% per annum in December. The inflation rate followed a similar pattern rising from just over 6% in April to 16.8% in December.

The close correlation between the rate of growth of M2 and the inflation rate is not surprising as there is a broad relationship that states that:
The inflation rate = the rate of growth of money supply - the rate of growth of GDP

In a situation where GDP growth is very small (such as has been the case in Jamaica for many years) the inflation rate will be approximately equal to the rate of growth of the money supply. Although the two are strongly correlated, there is a lag between them with money supply growth being the leading indicator and the inflation rate following in its wake.

An injection of liquidity fuels money growth

While it is quite clear that the recent spike in inflation had its genesis in the acceleration in the rate of growth of the money supply in the first three quarters of 2007, there may be a number of factors behind the increase in the money supply. Perhaps the most significant factor was the large reduction in the Bank of Jamaica's stock of Open Market Operations (OMO's), which fell by J$49 billion or 29.5% between March and October 2007. The BOJ's OMO's are used to absorb liquidity from the financial system and are used to control the growth of the money supply and thereby control inflation. The reduction in the stock of OMO's essentially put a large amount of liquidity into the financial system over a relatively short period of time, thereby fuelling the growth of the money supply.
The situation wasn't helped by the fact that fiscal policy was loosened significantly in the run up to last year's general elections with the government spending about J$15 billion more than it had originally programmed. With a significant loosening of both monetary and fiscal policy in 2007, the current spike in inflation should come as no surprise and does not require an appeal to external factors for an explanation.

Outlook

The silver lining in this cloud is the fact that since the major causes of our inflation are home grown, the cure for the problem can also be found right here and our inflation rate can come down even if oil prices do not retreat any time soon. The Bank of Jamaica began to tighten monetary policy in the first quarter of 2008 by both raising interest rates and increasing their stock of Open Market Operations. The new government has proposed a budget which should see a reduction in the fiscal deficit and therefore a tightening of fiscal policy. If these measures are implemented consistently, we should see a gradual reduction in the rate of inflation during the course of 2008 as the rate heads back into the single-digit range.

Charles Ross is Managing Director of Sterling Asset Management Ltd. Sterling provides medium to long term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor.

Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm

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