Why central banks punish the public by practicing of old economics of money. Let Us Question.

 

These days, economies, governments, firms and households are chaotic of four-decade high inflation and the faster phase of interest rate hikes by central banks. Since the last quarter of 2021, more than 50 central banks have already joined the bandwagon of interest rate hikes and shocked all corners of economies. Since modern economies are highly credit and finance - based, changes of interest rates being the prices of credit and finance can have wide chained effects on economic and social life of the public.

As money and money markets are largely controlled and regulated by central banks at their wishes under laws, the monetary policies of central banks have the ability to drive interest rates and credit/monetary conditions in economies and thereby living standards of the public. As economies also globally operate on international reserve currencies led by the US Dollar to carry on international trade and investment flows, monetary policies of the central banks in the US and other major developed countries have significant spillovers on countries across the globe. Therefore, all most all developing countries like Sri Lanka have no option but to join the policy bandwagon of the developed countries as all follow similar policy models and instruments. 

The incumbent chief of Sri Lankan central bank also secured the post by promising to act professionally and independently to tame the galloping inflation that he claims as the result of the excessive money printing during the tenures of the two former central bank chiefs. However, after nearly three months of his action, the inflation has risen to high inflationary regime of 54.6% in June from 18.7% in March reported at the time he assumed the duties of the post on April 7.

However, there are countries such as China who adopt policy models with a focus to target needy sectors of the economy in the light of promoting the resource mobilization, production, employment and living standards.

Therefore, the purpose of this article is to lay out the present monetary policy model generally followed by central banks so that its effectiveness especially in the current global inflation regime can be discussed in subsequent articles.

Why inflation arouses central banks to hike interest rates?

This is because of the old economic concept of the demand-supply equilibrium where money is only an intermediary to determine the level of the demand in the economy whereas the supply is largely demand-driven with lagged effects, subject to the availability of resources or the utilizable production capacity.

In this conceptual model, prices of goods and services are determined in monetary units through the interaction of the demand and supply, i.e., prices that make the quantity of the supply equal to the quantity of the demand. In the event the quantity of the demand which is driven by money is more than the quantity of the supply at a particular time, the result is the automatic increase in the price to ensure that the demand falls to match the available supply. The demand here means the spending on consumption and investment in the economy.

When this concept is applied to all goods and services in the economy, the average of all prices is the general price level. The increase in the general price level is known as the inflation whereas its decline is the deflation. Therefore, inflation or deflation is the result of the imbalance between total supply and total demand in the economy, regardless of the factors underlying. Accordingly, inflation is the result of the demand exceeding the supply and, therefore, the level and the trend of inflation depend on the excess of the demand over the supply.

As the demand is driven by the amount of money circulating at the hand of the government, firms and households, economists in the monetarist group believe that the inflation is the result of the stock of money available for transactions in the economy. Therefore, when the inflation rises harmful to the economy, they propose to cut down the stock of money until the demand is down to reduce the inflation or the growth of the general price level over the time.

This is where the central banks, who have the regulatory authority to control the amount and the flow of money, come into the equation to control inflation. As such, interest rate hike is the major instrument that central banks in present monetary policy models use to control the inflation in the economy. The underlying concept here is that when the price (interest rate) of the money is raised, its demand falls leading to slow down the growth of the money stock available for financing the demand of goods and services in the economy which has the potential to bring down the demand towards the level of the supply so that a desirable rate of inflation could be maintained.

In developed countries, the desirable rate of inflation or inflation target in their monetary policies is 2%. While there is no economic or statistical formula fort this 2% inflation target, they believe that this will encourage economic growth with price stability in the medium to long-term. As such, central banks in those countries believe the price stability as the inflation moving on average around 2%. Central banks in developing countries also follow this price stability concept and have their own inflation targets, for example, 4%-6% in Sri Lanka.

The inflation information used here is the change in the consumer price index, which is a measurement for the cost of living of household sector. Therefore, a  question remains as to whether this inflation is representative of the general price level relating to the demand-supply imbalance covered in the monetary policy.

Why central banks believe that interest rate hikes will reduce inflation?

Central banks believe the old concept of quantity theory of money. This concept that has emerged in 16^th-17^th century in western economics establishes a simple view that the inflation is always everywhere a monetary phenomenon. This is based on the quantity equation or Fisher equation that shows the total spending in the economy in two equal terms as given below.

    M x V = P x Q, where

• M is the total amount of the money stock or supply,

• V is the velocity of money or the number of times each money unit changes the hand to produce the total volume of goods and services,

• Q is the total volume of goods and services produced or the supplies,

• P is the general price of the supply

Accordingly, on the assumption that V and Q do not change in the short-term due to their structural nature whereas M and P variables are easy to change frequently, the equation states that whenever M changes, P also changes proportionately. For example, if M rises by 5%, P also has to rise by 5% as other two variables remain constant. 

The underlying belief for this is that as the production or the supply remains constant, any increase the money stock will push the demand up on the level of existing supply of goods and services where the direct result is the rise in prices in the economy operating through markets. This is the version of inflation popular among the opposition politicians and the public. That is, when more and more money is printed or produced, same chases after existing supply and causes increase in prices and inflation.

Therefore, this concept is an unreasonably simplistic view on the equilibrium of the economy, given the dynamism of the markets operating on global supply and demand chains. However, those who even complete PhDs in economics even at leading world class universities advocate this concept to create their professions, despite no empirical research is available to prove the concept. The set of economists who follow this concept is known as monetarists.

Therefore, this concept has become a good entry point for central banks, who are vested with regulatory instruments to control the money stock, to control inflation. As such, almost all central banks have got used to control the money stock by raising interest rates among other instruments when they see the inflation rising. They invariably refer to the inflationary situation as the demand-supply imbalance or the economy with demand higher than supply and believe that interest rate hike will bring down the demand towards the level of supply. The opposite is done when the growth of the economy is low with rising unemployment where the demand falls below the supply.

This is the monetary policy that all central banks are trying to adopt to keep the price stability in the economy, despite their quality of world class economists and economic data set. As such, central banks believe in magical power of money they have got to drive the economies with price stability through the demand in the economy so that the economic growth and employment prevail to foster living standards. However, they also state that they do not have the tools to influence or control the supply side of the economy for this purpose.

However, the approach they explain for this simple policy act has taken various shapes from time to time.

What is the present policy approach adopted by central banks in developed countries?

The most conventional approach has been to control the volume of bank credit as the money or money stock is created by bank credit. Interest rates, money printing, reserve ratios, etc. are the instruments that are used to target the growth of credit and money stock in order to influence the demand in the economy. Central banks in many developing countries still talk about the monetary policy in this approach.

However, when a parliamentarian questioned the US central bank (the Fed) Chairman at his half-yearly testimony held on June 23 at the House Financial Services Committee on the subject of recent money printing, money supply and resulting high inflation in the above version, the Fed Chairman responded that the control over the money supply is an old view and, instead, the present approach is to control the financial conditions to influence the demand in the economy while giving the time for the supply also to adjust accordingly. 

Accordingly, the Fed monitors conditions in all money and financial markets that cater to various demand sectors and expects the central bank interest rates to influence the demand through interest sensitive demand sectors. As such, financial conditions are determined by credit, bonds, stocks and derivatives markets where all these markets respond to interest rates and affect the demand, i.e., consumption and investment, of all sectors, government, businesses and households.

In this approach, the Fed Chairman clarified three prices that are expected to be affected by changes in financial conditions to influence the demand in response to interest rates. Those are consumer durable prices, asset prices and exchange rates where the Fed has no direct control over any of them. For example, when interest rates are raised, the resulting tightening of financial conditions is expected to lower the durables and asset prices and to appreciate the currency/exchange rate which all together cause deflationary pressures in the economy. However, the Fed has no idea of how much and how long it takes for this impact.

Therefore, the Fed’s monetary policy follows a nimble approach with successive interest rate changes over a gradual period of time while monitoring a wide range of economic data on financial conditions, employment and growth although any sensible correlation of such data with inflation is not established and disclosed. However, the monetary policy is called data driven whereas the public communication is nothing but a twist of technical words that markets seek to interpret in numerous ways to figure out or speculate on the next policy action and its the path. The present Fed Chainman recently stated at a press conference that the monetary policy largely works through expectations of market participants.

The present approach and rhetoric followed by all central banks in developed countries are similar whereas central banks in developing countries attempt to follow suit miserably as their economies, markets, financial conditions and governance systems are nothing any close to those of the developed countries.

What is the present monetary policy model followed?

The present model led by central banks in developed countries is the inter-bank overnight interest rate control or target-based open market operations.

In this exercise, central banks announce its own interest rates for overnight lending operations with banks whereas such interest rates known as policy rates function as the limit or the corridor for the inter-bank overnight interest rates. As such, central banks conduct market or lending operations on various terms mostly collateralized by government securities to inject or mop up funds in the banking market so that inter-bank overnight interest rates are within the preferred margin set by the policy rates.

For example, present policy rate is 1.50%-1.75% for the Fed, 1.25% for the Bank of England and 13.5%-14.5% for the Central Bank of Sri Lanka. While central banks mostly conduct overnight lending operations through auctions, term-based lending operations also are conducted to finetune the inter-bank market liquidity or financial conditions. As this is considered as a market-based policy model, direct instruments such as bank credit ceilings, interest rate caps and floors and reserve ratios are not generally used to influence banking sector financial conditions.

However, some central banks such as Reserve Bank of India and People’s Bank of China use such direct instruments too without blindly following the western market models to drive credit and financial flows to targeted sectors in line with the respective structures of the economy and macroeconomic targets.

In this western model, central banks also have targets for the desirable rate of inflation for the economy whereas the policy action is taken by looking at the level and trend of the divergence of the actual inflation from the inflation target. In that context, it is this policy interest rate that central banks change from time to time to influence financial conditions and thereby driving the actual inflation towards the target inflation. 

However, the whole policy operation is highly arbitrary without any empirical findings on the model success, given the dynamism of modern monetary economies as compared to tribal economies that existed in 16th-17th centuries with the applicability of the quantity theory of money.

It is in this context that central banks have embarked on the bandwagon to raise interest rates competitively at their wishes by claiming for getting back historically high inflation to their targets in the medium to long-term. However, why inflation reached at such high levels despite the price stability-based fashionable monetary policy models and the relevant rhetoric across the world is not questioned although the monetarists call for central banks to raise interest rates independently to tame the galloping inflation by disregarding severe recession threats already experienced from such policy tightening. 

It is in this context that the new chief of Sri Lankan central bank raised the policy interest rates by historic 7% on April 8, the day after assuming the post, and appeared before two press conferences bravely to promise his magical inflation control strategy (I have already released several articles on its macroeconomic risks with facts in the current plight of the economy.). 

However, the inflation has risen to high inflationary regime of 54.6% in June from 18.7% in March although he states that the current monetary policy stance is appropriate. Further, he has got the IMF press release to note the monetary tightening in early April this year although the tightening in fact commenced in mid August last year.

Therefore, now is the time for the general public to raise questions on such arbitrary policies that push the public to catastrophic living conditions that require no empirical research to establish. As such, the system change demanded by social activities must cover all such policy models in addition to the change in the political governance system.

However, the challenge here is the inflation ghost planted in the mind of the general public by old monetarists supported by politicians following them and the claim for the Devine power of the central bank to keep the ghost at the bay not questioned by the public, despite suffering from the ghost. Despite 72 years of existence of the central bank, the country' s economy has miserably collapsed in a matter of one year, despite the monetary policy of the central bank.

(This article is released in the interest of participating in the professional dialogue to find out solutions to enormous economic difficulties presently confronted by the general public consequent to the global Corona pandemic and subsequent disruptions and shocks.)

(The next article will focus on the questionability of the present monetary policy model in the current context of global inflation, hardships and extraordinary uncertainties confronted by the public.)

 

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 10 Economics and Banking Books and a large number of articles published)