JOHANNESBURG (Business Day) -- Call me a raving Friedmanite, but I am unable to find anyone who can give a satisfactory explanation as to why oil-price changes would be described as inflationary.
Newspapers have repeatedly talked about oil prices filtering into the consumer price index, with first- and second-round effects, yet the notion that such changes are inflationary is false.
Further, there is grave danger that labelling it such would confuse debate about institutional responses, particularly regarding monetary policy.
This would be a mistake.
The following model might help the mind around the problem: imagine a medieval market with no money, exchanging goods under a barter system. All goods have an exchange rate with other goods: two apples for one banana, 10 fish for a pig, 20 oranges for a barrel of oil.
Now, say the oil supply is changed and this affects the ratio at which oil exchanges with other goods. Maybe we now pay 30 oranges or three pigs for a barrel of oil but this doesn't mean that all prices of goods have increased.
True, some goods - say apples - have to be transported to the market and may therefore feel the impact of the oil price change, but this simply means other products' exchange rates will compensate accordingly. Some will go up, some will go down, but the net effect has to be zero.
Why? Because each individual's set of purchases is governed by their income constraint. They can't buy more than what they can afford.
Instead, consumers will reallocate their income according to the new price environment. Some individuals will afford the new oil price by giving up a movie ticket. Others will cap the number of times they use their cellphone.
Necessarily, demand for these products will drop, along with their prices.
In jargon, ceteris paribus, the collective elasticities must add up, or everything we know about downward-sloping demand curves goes out the window.
This is the theory, but it is difficult to filter from historic data. However, we should not confuse effects with causes. The oil price is not inflationary. What is inflationary is the Reserve Bank printing paper money at 15% a year.
Therefore, not only do rational consumers have to deal with a change in the oil price but also the distortionary effects of currency inflation.
The winners in the market are those with inelastic products who put their prices up first. The losers are those with more price-sensitive products, who in essence pay over the inflation tax.
Monetary fashion is to blame the private-sector credit market, indicated by M3, for inflation and point out that the Reserve Bank has no choice but to accommodate it. But it is the Reserve Bank that sets the interest rate and if any price is too low, people buy more.
It is my contention that if the Reserve Bank were to stop taking R5 billion seigniorage each year and raise rates by as much as 400 basis points, then this would curb the inflationary credit spiral we have seen for the past 20 years.
In turn, this would raise our levels of fixed investment, turning us from a nation of spenders into one of savers.
Neil Emerick is an independent analyst.
