My Town in Ohafia
In my town, there is one big shop. It’s got everything, groceries and also a fridge. In the evenings, locals gather in front of the shop to have a cold beer. It’s the “mall”, the centre of entertainment.
In normal times, prices in that shop reflect prices in Nigeria with a bit of margin for the cost of transportation. My town is an agrarian community with little disposable income. The shop owner knows that prices cannot be sky high because the residents can’t afford to spend large sums on imported luxuries. The shop sells local palm wine and Nigerian beer, no foreign brands; why? Foreign brands are more expensive, and the villagers cannot afford them. Let us assume a bottle of palmwine costs N1000 and beer cost N1,500.
The shop will make a significant capital investment and stock up in early December. They buy everything in December, including foreign soap, beer, and food. There is a lot of travel back to my town from across the world during Christmas. The town is full of “temporary visitors”. These visitors from around the globe bring in capital and consumer a lot. The prices in her shop also go up 100%. So a bottle of local palmwine goes up in price to N2000 and local beer to N3000. Imported beers are up 200%.
Read: Relationship between inflation and the unending devaluation of the Naira
Inflation
Let us now talk about inflation; inflation is often defined as too much money chasing few goods. Let’s take this definition to that small shop in Ohafia before Christmas. Although prices are higher in my small town, they reflect average prices across Nigeria with a margin for transport. Inflation is measured by the Consumer Price Index (CPI) change. Thus, to calculate inflation in my town, we would assume a basket of goods and services, including local palmwine, local beer and foreign imported beer. Suppose the cost of this basket was N5,000 in September 2021 and goes up to N5,500 in October 2021; in a very simplistic calculation, we can say the CPI basket has increased by 10%. Thus, inflation is 10%.
In December, the influx happens; more people poured into Ohafia, bringing capital with them. Prices across the town shoot up, beer prices shoot up, meat prices go up, there is a lot of cash chasing few goods. Goods that generally would not sell in the village, e.g., bottled water, become scarce and price spikes. The economic activity driven by retail trade heats up, income levels go up. This is classic inflation, and lots of cash are chasing a few goods. In economics, this is called demand-pull inflation. Aggregate demand is higher than aggregate supply in this town.
Read: Nigeria’s inflation rate rises to 15.63% in December 2021
Inflation expectations
So, if prices go up in Ohafia in December, is this inflation? The locals understand that prices will rise in December. This expectation of price hikes is also called inflation expectation. It is simply the rate at which people, consumers, businesses, and investors expect prices to rise in the future. Inflation expectation is an essential metric because if inflation expectations increase by 5%, actual inflation also tends to increase by 5%. In other words, the residents of my town expect that inflation will go up, and it does. They also change their behaviour; if they would till a field for N500, they will request N1,000 in and only in December. This expectation thus drives the increase in the CPI in Ohafia, even without any actual increase in the cash flow into Ohafia.
This expectation theory is why inflation is so dangerous and difficult to control. Suppose residents in Nigeria expect inflation to rise. In that case, they demand more cash in higher wages to meet their needs and retain their purchasing power. Their employers then raise prices to enable them to meet the new wage demands of labour, and thus costs of goods and services rise. This creates what economists call a wage-price spiral where the expectation of inflation alone drives prices up. Therefore even when there is no money supply, expectations can rise and keep prices higher.
Thus Nigeria inflation rate is 15.63%. Suppose Nigerians expect inflation to continue to be 15.63% in the near future. In that case, 15.63% rate becomes built-in or anchored. The Nigerian Labour Congress, for instance, will demand a new wage contract. This anchoring of inflation cements higher prices in the economy.
However, back to Ohafia, the whole village knows that come what may, all prices will fall in January because the money supply will drop as the visitors leave town. A deflation expectation now replaces the inflation expectation. Consumers start to wait for future lower prices, and they stop shopping. In the shop in my town, the unsold bars of Irish Spring soap is marked down to encourage shoppers to buy before January, when demand will collapse. Prices will keep on falling as January approaches. The shop owner understands that, and even if there is still cash in the system, the shop must sell all highly-priced imported goods. This deflation expectation is happening in Japan; the Japanese consumers are flush with cash but refuse to buy; they expect prices to keep falling. Thus even with trillions in savings, prices keep falling, and growth stalls because the expectation of falling prices is now anchored or built into the minds of the Japanese consumers.
What can stop inflation?
Is there anything that can prevent the prices of goods and services from rising in my small town rising in December? Yes, more supply of goods and services. Remember, my town has one store, but what if a bigger store got more supplies every day and local prices reflected the same price in a big city like Aba. Then there will be no significant rise in prices. The small shop won’t hike prices, because if they do, the consumers will go to the other shop and buy the same goods.
Thus, we have to update our definition of inflation to say inflation occurs when there is a lot of cash chasing a few in-demand goods, and there are no substitutes. In the large city of Lagos, if everyone expects fuel supply to fall, there will be long lines at gas stations, and prices will inflate upwards. However, if the NNPC announces that there are a lot of PMS tankers offloading, then prices will fall. Thus supply in sufficient quantities not only reduces prices but installs the expectation that prices will fall further
In summary, inflation expectations are an essential tool in reducing the pressure of rising prices. The Central Bank of Nigeria and the Ministry of Finance can anchor an inflation target in the Nigerian consumers through pronouncements and actions. Inflation anchoring must be backed by a productivity increase that increases the supply of goods and services at the same or lower prices.
