Domestic costs drive inflation, not import prices

For a long time, the Monetary Authority of Singapore (MAS), our central bank, has used the management of the Singapore dollar exchange rate as the chief tool to influence inflation locally. It argues that since Singapore’s economy is so open to external trade, inflation tends to come in via rises in prices of imported goods. By shifting our exchange rate up or down, MAS compensates for changes in import prices, thus moderating inflation.

An economist from the National University of Singapore says this is less than half the story. His conclusion is that managing the exchange rate is not good enough for the task.

In an article published in the Straits Times, 29 July 2010 (headlined: Rising Sing$ may not keep prices low), Tilak Abeysinghe dealt with the question: Why are consumer prices rising while the Singapore dollar is appreciating and import prices are falling?

His answer opened with these words:

From 2006 till last year, consumer prices rose by 3.1 per cent annually while import prices fell by 2.3 per cent. Last year alone, import prices fell by a hefty 8 per cent, while consumer prices went up by 0.6 per cent. The general trend of import prices since 1981 has been downwards and consumer prices upwards. Given Singapore’s extreme dependence on imports, this has puzzled some.

My co-researcher Choy Keen Meng and I examined this puzzle and found, somewhat unexpectedly, that non-tradeables account for 55 per cent of Singapore’s consumer price inflation, while import prices account for the rest.

Further down, he explained what he meant by non-tradeables. These include labour costs, rental and storage costs, government fees and charges and so on, he explained.

What he is saying therefore is that even as we manage to enjoy lower import prices through the deliberate strengthening of the Singapore dollar, this is more than wiped out by increasing domestic cost elements such as salaries, rents and payments to the government. The result is that we still continue to suffer inflation.

So why not strengthen the dollar some more until it balances out domestic cost increases? There’s a limit to how far the dollar can strengthen; at some point, it will severely affect our export competitiveness.

Abeysinghe was too polite to discuss the far-reaching implications of his findings, especially on policy, but they are not hard to see.

Firstly, the long-standing belief that inflation is mainly the result of external price movements may have blinded our policy-makers to the true impact of domestic cost pressures. Has our government been raising fees and charges, and pushing up land prices in the mistaken belief that these do not have much impact on inflation?

Secondly, if salaries are another domestic cost component that has been pushing up prices of goods and services in Singapore, this begs another question: whose salaries? In 2009 when we faced a worldwide recession and Singapore’s GDP contracted an inflation-adjusted 1.3 percent, the median household incomes of all sectors (by housing type) fell. However, those living in more modest homes suffered the greatest contraction in income. Here are data from a paper titled Key Household Income Trends 2009, from our Statistics Department.

Note: the dataset is restricted to households with at least one working member. “Real change” means after adjusting for inflation.

What you see in the table is part of a much longer trend wherein the income gap widens year after year. There is a tendency for salaries to increase more for those already earning more, or in the case of 2009, to decrease less when bad times hit. But salary-rises feed into overall inflation, and inflation affects the poorer segments of society disproportionately. This is because they spend a larger portion of their income. The rich save a substantial part of their income, putting it into interest-bearing or dividend-producing assets.

Then there is the huge influence that the government has over land prices. They impose massive redevelopment charges when an owner wishes to redevelop a piece of land for more intensive use while empty parcels of land are not auctioned off until a minimum bid price is reached. This minimum bid price appears to be quite arbitrarily set. Between them, the ever-rising cost of land results in rents going up inexorably, cyclical downturns excepted.

In turn, land for public housing are then revalued to catch up with notional “market” values (which as explained in the preceding paragraph are heavily affected by government action), and the selling prices of flats marked up accordingly.

In other words, the government’s failure to act effectively on inflation hurts the less well-off particularly hard. The belief that tackling inflation is a job that can be left to the MAS managing the exchange rate is misplaced. There are plenty of domestic cost pressures, many related to government policies, that have a greater effect.