Inflation: will prices ever go back down?

The law of gravity—what goes up must come down—applies to everything but prices in Nigeria. Every time the NBS releases inflation numbers, we have new evidence that prices of goods and services are not just rising but also at a faster pace. When inflation rises, it basically means that your money cannot go as far as it used to.
 

The annoying thing is that when prices of things like food rise, they never seem to fall. In today’s world, where the cost of nearly every product has risen with near stagnant wages, the question of why prices rise and never seem to fall has been top of mind.

This is why I wasn't surprised to see a tweet asking, “how come prices don't fall in Nigeria?” While I understood the sentiment as a Nigerian consumer, as an economist, I knew the answer won’t be so clear cut.

I’d even go as far as positing a reworded question: “when prices increase, why don’t they return to former levels?” To provide an answer, we will look through the lenses of economic theory and real-life applications.

Let’s dive in. 

It’s a worldwide movement

We first need to understand that prices aren’t rising only in Nigeria; it’s a global phenomenon.
The swift rise in commodity prices, from energy to food, has fuelled inflationary pressures and rattled several economies worldwide. Global inflation is projected to climb to 7.4% this year from 4.7% in 2021.

According to the Food and Agriculture Organisation (FAO), the global food price index (which measures the monthly change in the international price of food items) has risen to 154.2 points (June 2022), 23% higher than the 125.3 points recorded in June 2021.

We’re already familiar with the situation in Nigeria, which is pretty much the same. Commodity prices are also surging. 

Sadly, this price hike hurts Nigerians’ living standards. In short, people are not faring well. Inflation which has been double-digit for almost seven years, recently rose to an eight-month high of 17.7%. This means prices rose faster in May than in the previous eight months. Food inflation is also at 19.5%, and chances are it will keep rising. For example, the price of an egg that used to be ₦50 two years ago is now up by 60% to ₦80 today.

To reiterate, rising food prices are not Nigeria-specific. It is a global phenomenon, and everyone is feeling the pinch. Even the US’ latest inflation figure (9.1%) has hit a new four-decade high. However, the difference is that rising prices have a bigger impact on poorer households with lower wages. This is because poorer households spend a larger chunk of their incomes on necessities—food, housing, and transportation. So, with rising prices, a rich household could skip their family vacation for the year or cut back on their diesel expenditure and buy a petrol generator. But a poorer home would have to miss a meal and possibly withdraw their children from school to survive. For a country like Nigeria, where over 40% of the population lives below the poverty line, rising prices pose a more significant threat for us than countries like the US or China.

Essentially, the lower our wages, the stronger the impact of rising prices. So, the problem isn’t exactly that prices are rising but that it’s more difficult for us to afford goods and services with wages that aren’t growing as fast.

However, at the very least, you won’t be wrong to expect price movements to reflect the changes we see in large-scale contributors to inflation (supply constraints, excess demand). What’s jarring though, is that even after these inflationary pressures get “resolved” (let’s say supply constraints go away), it still takes a while for prices to adjust.

This is called price stickiness.
 

What is price stickiness?

Price stickiness, sticky prices, (or nominal rigidity if you want to get technical) is when prices don’t fall or rise as quickly as they should, i.e., prices resist changes in demand or supply. What happens is that the price of the good or service increases and stays that way (sticks there) regardless of demand and supply changes.

There are a few reasons why this happens. First, suppliers of goods and services don’t continuously adjust prices as quickly as economic shocks affect the economy. For instance, a restaurant has to print menus to reflect prices to customers. Restaurateurs would argue that it wouldn’t be prudent to print new menus every time prices change. Rather, they will wait till prices reduce to such an extent that printing new menus would be worth the cost. Another reason could be that suppliers wait to see how their competitors respond to changing prices. If the price of tomatoes reduces today, tomato sellers in Mile 1 market would first wait to see whether other sellers reduced prices before changing their prices.

Another reason could be that input costs might not be changing. For instance, we covered that bread prices are increasing due to input costs like wheat and eggs and costs like diesel. If diesel costs were reduced but bread input costs continued to rise, bakers would not automatically reduce prices because a reduction in diesel prices wouldn’t cause a significant enough reduction to the cost of bread to warrant a price change.

Long-term contracts also cause sticky prices. If you have a contract to supply a chain of hotels with cable services for two years and the government suddenly increases (or reduces) taxes for cable service providers, you can’t immediately change your price to reflect the new market reality on a previously signed contract.

These reasons apply to increases and reductions in price because prices could be sticky upward and downward. Downward sticky prices are when the price of the item doesn’t fall as fast as they rise, while sticky upward prices are the opposite. Our focus is on sticky downward prices because that's what most people experience and will likely continue to experience in these times of inflation (global and domestic).

Let’s use economic examples to contextualise the definition of sticky downward prices.

Globally, there has been a persistent rise in food prices over two decades. From the graph below, food prices have not returned to their level since 2000, despite some declines—evidence of sticky downward prices. Compared to 2000, food prices have increased by 184%. 

In the UK, the popular Freddo chocolate bar has continued to rise from the 1990s to date, despite times of economic boom (characterised by the low cost of production) and even a global decline in cocoa prices. The price moved from 10p (1994), to 15p, 17p, 20p, 25p and then 30p (2021). The price of this chocolate has changed so much that it has become a measure of inflation in the UK.

Bringing it home, a good example would be the price of yam. If you noticed, you no longer buy a tuber of yam for ₦300 or even ₦500. The price just keeps rising to ₦700, ₦900, ₦1,000, ₦1,200, and ₦1,500, and today, a medium-size tuber of yam is going for ₦2,500. The price of yam didn’t fall even during the harvest season. Another good example is the price of bread, which has moved from ₦350 to ₦500,  ₦650, and ₦800. Demand and supply factors play a considerable role here.

It’s not just food, though. Labour costs (wages) are also sticky downwards. It's much easier for wages to increase than reduce because wages are based on contracts. So, if economic conditions change (recession), it is difficult to reduce wages. Suppose you negotiated a monthly salary of ₦200,000 in 2021, and the company you work with is beginning to have a hard time due to higher operating costs (like most companies are right now), your salary does not change overnight, and it's sticky downward. In addition, according to Keynes (who some might call the “father” of modern economics), companies are averse to wage cuts in times of a recession to maintain the productivity of existing workers. Also, when the price of a good increases because the associated labour cost goes up, it's unlikely that the labour cost will be reduced materially in the future. Thus, the price of the goods or services doesn't come down either.

We now know why prices don't fall as fast as they rise, and sadly, this will be the case for some time in Nigeria and the world as inflationary pressures persist.

But did you know that a sharp and consistent price decline is also not a good idea? 

Fast falling prices are not ideal

Deflation, the sharp and persistent decline in the price of goods and services in an economy, is the opposite of inflation. Basically, the inflation rate becomes negative. Deflation happens when aggregate demand falls compared to the number of goods or services available in the economy and when there’s a decline in money supply and credit to business owners.

In times of deflation, the purchasing power of consumers is higher. This means that your nominal income has more value, and you can buy much more than your money’s worth. It sounds like music to our ears, but while it might be good news to the consumer, it is not beneficial to business owners and the wider economy because businesses borrow (collect loans) to produce. During deflation, it becomes a problem to pay back because the loan collected has increased in value, meaning borrowers will have to pay more.

The wider impact is negative on the overall economy because productivity could decline due to lower economic activities which would contract money in circulation and cash available for credit. In deflationary times, consumers are incentivised to save more as they expect prices to keep declining in the future (essentially reducing their consumption in the present). Meanwhile, borrowing costs (cost of credit) to businesses increase thereby reducing spending and output levels. In all, growth is contracting from supply and demand (think Y=C+I+G+X-M). And the loop continues!

Let me tell you a quick story about Japan. In the late 1990s, Japan went through chronic deflation for fifteen years after an asset bubble, which was quickly followed by a damaging financial crisis. Prices started falling, so consumers kept deferring their spending because they expected prices to fall even lower in the future, severely depressing the Japanese economy. The consumer price index averaged 0.09% between 2000 and 2021.
 

To solve the catastrophic problem, the late Shinzo Abe stepped in with an aggressive economic policy response. The most important and significant was the quantitative and qualitative easing (QQE) introduced by the Bank of Japan in 2013. The framework was hinged on the Bank's strong and clear commitment to achieving a price stability target of 2% and large-scale purchases of short- and long-term government bonds to reduce interest rates. The two targets, coupled with favourable economic conditions at the time, anchored inflation expectations and encouraged spending within the economy.

Still, it has taken Japan so long to come out of deflation. The country still experienced negative inflation in 2021 (-0.23%). It’s just recently that inflation in Japan rose to 2.5% (May 2022)—the highest level in about seven years.

Basically, inflation directly targets consumers (the demand side of the economy) while deflation targets the business owners (the supply side of the economy). The market disequilibrium then affects prices.

To sum it up, it’s not enough to wish for falling (deflation) or rising (inflation) prices. Balance is key. Prices should not be rising too fast, nor should they be falling too quickly.

As we have seen, both situations are not a great world to live in. 

Is there a sweet spot?

Unsurprisingly, this conclusion means the job of central banks everywhere is not an easy one. Their ultimate task is to ensure price stability, which can be threatened either because of higher or lower inflation expectations.

To an extent though, you could say that the potential existence of inflation has structurally shaped central bank policies for decades. Maybe Germany’s hyperinflation in the 1920s was just too painful to bear. That’s why you might hear Andrew Bailey, the governor of the Bank of England (the U.K’s central bank) announcing how prepared he is to take bigger steps to bring UK inflation back down to 2% (from 9.1%). Also, as we saw with Japan, deflation is worth paying attention to as well. That’s why some might even argue that Shinzo Abe’s great economic achievement was appointing a central bank governor that was committed to deploying massive and prolonged stimulus to jumpstart the Japanese economy.

All of this points to the important role of an appropriate monetary policy stance that is not just communicated properly but is also consistent. That’s because a big part of managing inflation expectations depends on economic agents—consumers, and businesses—having full confidence in the central bank pursuing its monetary policy objective.

So while the CBN’s has a clear goal of keeping inflation at 6-9%, the real work comes from adequately defending that target. That means acting swiftly and credibly to alter the monetary policy rate (the CBN’s key tool for controlling inflation) when necessary. The recent rate hike is Nigeria’s first in nearly six years. The last time the CBN hiked rates was in 2016 when a near-collapse of the country’s exchange rate regime forced the CBN to take drastic action. I should add that even that 2016 move cost the central bank its credibility as the devaluation came just a few weeks after the CBN promised it will not devalue.

In the CBN’s defense though, Nigeria’s economy is special for lack of a better word. For example, our inefficient economy is plagued by an unproductive agriculture sector that can’t meet local consumption. Till now, there is even wide disagreement about the true cause of inflation, which consequently makes it hard to manage. This makes it difficult for monetary policy to have the desired impact you might see with the Federal Reserve in the US.

As a result, our overdependence on CBN headquarters to fix Nigeria’s economic problems needs to be checked. Make no mistake, we believe the CBN should be held accountable for missed inflation targets. Still, that question of how soon can we expect price levels in Nigeria to return to “normal” will depend largely on our ability to tap into a fuller suite of policy tools that are targeted at improving the structure of our economy.