Why present monetary policies are meaningless policy exercises. Let us investigate.
The last article released on July 2 in this blog presented the foundation of the present monetary policy models followed by central banks in general. Accordingly, this foundation is built mainly on four conceptual pillars. First, the prime objective of the policy is the price stability based on the fear of inflation or changes in the general price level as predicted in the quantity theory of money. Second, the policy affects the general price level through the demand side of the economy where the supply side of the economy is beyond the policy control. Third, the inter-bank overnight interest rate is the policy conduit to affect the demand side. Forth, central bank policy interest rate is the target set for the inter-bank overnight interest rates.
Accordingly, the present policy model
is largely the policy interest rates-based open market operations or money
printing where the policy decision primarily rests on the appropriate level of policy
interest rate to drive the inter-bank overnight interest rate. As such, a quite extensive rhetoric exists as to how the policy
decision gets eventually transmitted to secure the policy objective of the price
stability. Therefore, given the conceptual policy framework
diversely presented without the support of empirically established facts, it is
not necessary to mention the controversy that exists on the effectiveness of the policy
across the globe.
However, there are PhDs received and
undertaken on various topics relating to the implementation and effectiveness
of the monetary policy at almost all universities in the world whereas
extensive research work prevails among the economists without empirical findings
acceptable to establish the monetary policy effectiveness as claimed by central
banks and supporting economists.
Therefore, when cyclical instabilities
such as financial crises, recessions and booms confronted by the economies
globally are considered, it is questionable whether the public at large really
benefits from the monetary policies as presented in the present models,
especially in the current context of the four-decade high inflation rising day
by day, significant erosion of living standards consequent to the loss of
purchasing power and resulting grave uncertainties in economic activities and
markets across the globe.
Therefore, the purpose of this article
is to present 10 key areas that can be used as a guide to question the effectiveness of
monetary policies in the current world. It should be noted that these are
also views by the author based on his inside knowledge and exposure from the ground realities in
contrast to various hypotheses presented by many in monetary policy advocacy.
1. The quantity equation not being appropriate
for modern monetary economies with global supply chains and resources
This concept has been mathematically derived from largely closed economic societies in 16th-17th centuries with scarce currency notes and coins used for medium of exchange function of money. Therefore, at any point in time, it is stated that the general price level of goods and services available in the economy should be proportional to the amount of money in circulation.
As such, on the assumption
that the velocity of money and the supply or the availability of goods and
services being constant, the cause of the change in the general price level
between any two points in time is the change in the amount of money in
circulation. This means that the channel that the money causes changes in prices is
the demand for goods and services driven by money on the unchanged supply. This is the reason
for the belief that the monetary policy does not affect the supply side of the
economy.
However, in modern monetary economies,
money has become a factor of production whereas credit/debt function of money (deferred
payment) drives both demand side and supply side together. Although investment
of money in production is initially considered as part of the overall demand or
spending, such investment spending is directly involved in simultaneous
increase in supply as the modern technology, information and business
management help both demand and supply to be determined jointly with hardly any time
lags. Even when the domestic productive resource base is limited, a country can
import resources on credit and raise the supply. The productivity enhanced by the monetary system also helps the supply side.
In current marketing systems, the
supply can create its own demand, similar to what is stated by say’s law.
Therefore, the existence of the cause-effect chain between the money and the
supply side of the economy is easy to understand. Further, as both money and
goods (and services) flow cross border, domestic prices will be driven by
various cross border factors outside the domestic money in circulation. Therefore, the existence
of the direct money-inflation hypothesis presented in the monetary models is
not justifiable.
2. The current global inflation being a supply
side phenomenon
In the basic macroeconomic theory, any
change in the general price level or inflation is recognized through the
demand-supply imbalances at two points in time. Therefore, although the primary
reason for inflationary pressures is considered as the excess demand over the supply, its
cause could be the decline in the supply over the demand or the increase in the
demand over the supply. However, the monetary policy always recognizes the
reason for the price change or inflation as the increase in the demand over the
supply.
However, it is well accepted that the overriding reason for the current global inflationary pressures is the supply side constraints including disruptions in global supply chains caused by the Corona pandemic from the beginning of 2020, Russian invasion in Ukraine since February 24, 2022, and connected uncertainties. Therefore, this inflation is caused by supply side shocks which is well established from the trend of the real GDP growth numbers across the globe.
In contrast, the monetarist argument for
high inflationary pressures is the excess demand caused by the exorbitant
increase in credit and money through the printing and government deficit spending in
2020 and 2021 under historically loosened monetary and fiscal policies across
the globe to fight the social and economic impact of the Corona pandemic. Therefore,
these monetarists largely go by the numbers on monetary base and inflation without any reference to the human crisis addressed by those policies.
Therefore, while governments are trying to ease the supply side and market bottlenecks to control inflation, central banks as advocated by monetarists are tightening the monetary policies faster to cut down the growth of the demand to pre-pandemic levels. In fact, central banks recognize both supply side and demand side reasons and state that they attempt to slow down the demand side as they don’t have tools to deal with the supply side.
However, monetary policy tightening at this time of global
inflation is not the solution to the real cause of inflation being the supply
side shocks. Therefore, high interest
rates and tightened credit/financial conditions due to tightened monetary
policies would add to supply side bottlenecks through new constraints in
financial supply chains and push inflation further through the increased cost of production.
However, monetarists in developed
countries believe that the economies have strongly recovered from the
pandemic-hit recession with historically tight labour market (low unemployment
rates and higher wages) and, therefore, monetary tightening is appropriate for
inflation control. The opposite view is that the recovery numbers reported are
from the low base in 2020 and the prevailing supply side bottlenecks including
excess capacity and lower productivity are indicative of the recovery still below the
pre-pandemic levels. Further, low unemployment rates relate to structural
changes in the labour force participation such as massive withdrawals, decline
in formal sector/office employment due to work from home practices and diverse
employment opportunities driven by new IT.
3. Policy transmission channels not detectable
and measurable
It is believed that the monetary
policy affects the demand and inflation with time lags though a series
of responses from markets and changes in underlying economic activities. The
main conduit is the credit and financial conditions that fuel the economy.
There is no controversy over the effect of interest rate changes over diverse
markets and economic activities in modern monetary economies as the interest
rate is the price of money which drives all prices in markets through the cost of production and risk premium.
For example, even informal money
lending taken place on currency held by the public will respond to changes in
bank interest rates although such lending may not be funded by any bank
borrowing. Further, investment horizon will shrink in the event of a
significant hike of bank interest rates since real sector investments now have
to enter into businesses with higher risks benchmarked on bank interest rates.
Therefore, central banks can have large controls over interest rates as they
have the bureaucratic power of printing or supply of money.
However, effects of such interest rate
changes have to transmit across the economy through interest sensitive economic
activities whereas such sensitivity differs in the extent and the time across
the activities. For example, interest rates on money market funds
such as inter-bank and bonds respond to policy rates to a great extent almost
overnight whereas other credit and capital markets take more time for the rates and volumes to respond. However, the inter-bank market volume will adjust to policy
rates next day itself as central banks have no problem of change in money printed for keeping the inter-bank liquidity in line with the policy rates.
The monetary policy is geared to
change the real quantity of the demand to match the real quantity of the
supply. However, they do not have facts on interest sensitivity of various
demand sectors and the time lag involved in. Recently, the US Fed Chair stated
that policy rates are expected to affect the prices of consumer
durables, assets and foreign currency (exchange rate) to have subsequent impact on inflation. This means that open economies face policy transmission channels
both domestically and internationally. However, the Fed does not have any
empirical research to prove it since those markets also respond simultaneously to
diverse forces and shocks in addition to policy rates.
Therefore, as the policy transmission depends on the development level of markets that varies significantly within and across the countries, monetarists cannot agree on any specific phase of the policy transmission although they have horoscopes for transmission-based inflation control.
For example, the European Central Bank after 20 years of its operations commented on June 15 that the fragmentation prevailing among the Euro area countries as revealed by government bond yield spreads hinders the policy transmission and, therefore, a new set of anti-fragmentation tools would be implemented in due course to improve the policy transmission across the Euro area. However, given wide differences among economies of Euro countries, nobody can expect an even transmission without fragmentation.
Further, as
the Euro area economies are more bank intermediation based in contrast to the
US economy with wider financial markets outside the banking system, the policy
transmission and thereby policy tools vary significantly between the US Fed and
European Central Bank. Information profile and outlook also differ
between the two.
Central banks in developing countries
frequently blame such transmission bottlenecks for the ineffectiveness of the
monetary policy. For example, Sri Lankan central bank on April 29,2018
implemented interest rate caps to accelerate the policy transmission and to enhance credit flows to the economy. The central bank also forced banks in last
April to pass the historic policy rate hike of 7% though a parallel rise in
deposit interest rates in order to correct anomalies in the interest rate transmission. However, Sri Lankan central bank chief later commented
that interest rates overshot, and policy tools would be implemented in due
course to correct it.
Therefore, the monetary policy without
detection of its transmission channels and time lags with the predictability
loses its public accountability. However, even though a large number of PhDs have been offered and extensive research is undertaken on the monetary policy
transmission mechanism, central banks just carry on monetary policies by just referring to transmission mechanisms they conceptually elaborate as existing in
respective economies.
4. The monetary policy being a blunt tool with a conflict between prices and real sector activity
Conflicting effects of the monetary
policy actions on prices and economic activity are well known as modern economies
run on credit and finance. Although monetary policy in present models is
largely practiced for the price stability tracked by the consumer price index, it
always has opposite effects on economic activities, i.e., production,
employment and real income. This conflict between the prices and economic
activity is largely prevalent as the current policy models rest on interest
rates that have blanket effects across the markets in the economy. Therefore,
monetary policy is labelled as a blunt instrument.
Therefore, the world has extensive
experience that monetary tightening carried out for the control of demand-driven
inflation invariably causes economic downturns and recessions. The fine example
is the recession projected from the next year consequent to the current phase
of the monetary tightening across the world. Therefore, some economic analysts
state that developed countries led by the US may have to reverse the present
monetary policy tightening before inflationary pressures get reverse.
All central banks are concerned and
conscious of this downside risk of low growth and higher unemployment, but
expect a soft landing based on various assumptions. For example, the US Fed
Chair stated at the last press conference held on June 15 that getting inflation back
to 2% by end of 2024 with the unemployment rate risen to 4.5% as compared to
the current 3.6% of 50-year low is a good outcome and soft landing. However,
these are just views without the support of empirical data or findings.
Therefore, the mostly advocated view is the hard landing with a significant
decline in the growth and employment although there is no proof that the
inflation will slow down to the monetary policy target of 2% in developed countries.
It should be noted that the developed
countries can bear such hard landings as their fiscal policies cover social
safety nets including unemployment benefits whereas households in developing
countries will confront unemployment and poverty without any fiscal support due
to heavy indebtedness of the governments. As such, the current phase of
historic monetary tightening in Sri Lanka already in economic collapse with
acute shortage in foreign currency and annual inflation rising over 50% will no doubt
end up in catastrophic landing with widespread civil unrest and poverty.
5. Monetary policy being a form of Ponzi scheme through bank and government liquidity management facility while expecting a trickle-down credit delivery
system for the rest of the economy
The present policy interest
rates-based policy model is to facilitate the daily liquidity management of
banks where banks with excess liquidity can invest such funds at the central
bank while deficit banks can borrow from the central bank at fixed policy
rates. Further, intraday liquidity facility given free of charge to banks also
facilitates the daily liquidity management.
In this monetary environment, credit
needs of the government, businesses and households are expected to be fulfilled
by banks and markets based on risk management approach. As credit to the
government is considered greatly risk free in the present monetary system
design, credit to the government gets the high priority. Credit then flows to large
corporates and businesses with low risk profile. Therefore, the trickle down of
credit to meet the needs of the majority businesses and households is low at
the tail end due to high risks although they are the majority in the economy.
As such, the distribution of credit created on the central bank’s monetary base is highly skewed towards the government and big businesses as the present policy model does not pay any attention to the distribution of credit across the economy. The Fed Chair at the Senate Testimony held on June 22 sated that the credit allocation was not a job of the Fed, and it was a job for the government and markets.
However, the Fed during both financial crisis 2007/09 and Corona pandemic 2020/21 purchased a large volume of mortgaged backed securities and private market securities and provided refinance to banks for SME lending based on part funding from the Treasury under the CARES Act which can be considered as credit allocation to identified sectors. The present discount window of the Fed is also a credit distribution tool to finance businesses and households on short-term basis. Further, the Federal Reserve and Economic Equity Act passed on June 21 requires the Fed to carry out its duties in a manner that supports the elimination of racial and ethnic disparities in employment, income, wealth and access to affordable credit. Therefore, the new laws applies to the Fed's conduct of monetary policy, supervision and regulation of banks and financial institutions.
The European Central Bank also has short-term and long-term refinancing operations for onlending to businesses at specific interest rates. However, many central banks in developing countries including Sri Lanka do not have a credit distribution policy to cater to priority sectors such as exports, import substitution and SMEs even though the relevant statutes have mandated the monetary policy to cover credit distribution to identified sectors and economic activities.
Further, all central banks carry on
open market operations on term-basis on government securities to control the
yield curve at various points/segments outside the inter-bank overnight
liquidity operations. Such-term based open market operations provide the liquidity
for fiscal deficit financing through secondary market. Central banks in
developing countries also facilitate government foreign borrowing through the
foreign currency reserve funded from the proceeds of such foreign borrowing.
As such, the skewed credit
distribution through markets based on business risks is the major source of resource
distributional disparities in modern monetary economies as the credit/finance
is a prime source of profit and wealth generation in the modern monetary capitalism. Therefore,
present monetary models focusing on the facilities to the liquidity management
of banks and government are not beneficial to wider sectors of the economy.
As such, present monetary policy models largely take form of Ponzi schemes relating to governments and banks who operate quite similar to Ponzi schemes on rollovers of debt without the ability to service debt out of income. Ponzi schemes are the businesses that run on rollovers of debt where existing debt is serviced by new debt. Therefore, present central bank monetary policy and money printing models that cater to government and bank also are Ponzi operations that run huge systemic risks in the economy.
6. Inflation calculation not representative of
macroeconomic inflation arising from demand-supply imbalances
All central banks use the change of
the consumer price index released by the state statistician as the rate of
inflation in their inflation targeting monetary policies. This consumer price
index covers the basket of selected goods and services consumed on average by
the household sector and generally depends on wage income, fiscal subsidies and
administrative prices largely relating to consumption. Therefore, the index is
largely driven by the food and energy whose price movements are driven by
seasonal factors.
Therefore, prices of investment goods
and services as well as consumption of the business and state sectors are not
covered in the index although the demand side in macroeconomics entails consumption and
investment of all state, business and household sectors. As such, inflation
measured by the consumer price index shows only the movement of the cost of
living useful for wage negotiations and fiscal support for the households and,
therefore, targeting this inflation in the monetary policy is highly
inappropriate as the monetary policy is expected to influence the whole demand
side for the purpose of overall or general price stability.
As the consumer price index moves seasonally
on food and energy prices being not responsive to interest rates, central banks
use the measure of core inflation calculated from the consumer price index
without food and energy items and call it monetary policy responsive inflation.
This is an utter myth as the consumer basket without food and energy contains
only a subset of manufactured consumer goods such as garments and footwear and personal services which are not sensitive to monetary policy
actions or interest rates. Although central banks call the core inflation as a
better inflation indicator for the monetary policy, they never target the core inflation
in the monetary policy.
Central banks also misinterpret inflation numbers by taking annual average, quarterly average and year-on-year rates whose numbers differ. As the inflation number is arrived on the previous period index, the base effect is also cited as a factor that changes inflation rates. As such, this inflation is not a realistic variable to be targeted in any public policy. Therefore, the recommendation to target the index value itself in the monetary policy to be more accountable is disregarded as central bank are never new thinkers.
Further, the Fed Chair at a Bloomberg interview held on June 29 commented that the Fed now only understands the present inflation which was misunderstood initially as transient consequent to temporary disruptions in global supply chains. The Governors of the Bank of England and European Central Bank who participated at the interview also agreed with the comment. It is surprised that these central banks with extensive experience and literature in the price stability-based market driven monetary policy state that they did not understand the inflation until it becomes a level of four-decade high.
However, the inflation defined in the
monetary policy is the macroeconomic inflation or change in the general price
level driven by the demand-supply imbalances. Therefore, present inflation
targeting monetary policy models are highly misguided by the consumer price
index. Further, the inflation concerned in macroeconomic equilibrium models is the price level driven by the
demand above the potential output in the economy. Therefore, if the productive
resources and capacity are available, inflation is not a macroeconomic problem as fiscal and monetary policies can encourage the utilization of resources and capacity in contrast to
the present view of the policy tightening based on consumer price index-based
inflation.
7. Policy cycles and connected asset bubble risks
Although central banks state that they
conduct the monetary policy to secure the price stability or inflation within the target
in the medium to long-term, monetary policies tend to follow own cycles in
response to macroeconomic trends as indicated by the real GDP growth, consumer
inflation, unemployment and spending. Therefore, the past monetary policy
actions show a period of policy tightening followed by another period of policy
relaxation where the length and intensity of the two phases in each cycle defer
depending on the reading of macroeconomic data set by the respective central
banks.
Further, the policy cycles largely
follow the US monetary policy cycles with different lags as the US dollar is
the leading global reserve currency which has spillover effects through
exchange rates and international trade and investment flows. In fact, the
policy cycles of developing countries largely connect to the US policy cycles
with the attempt to stabilize foreign investment flows and exchange rates
through manipulation of domestic interest rates. As such, the present phase of the global policy
tightening is the same practice followed in line with the US policy tightening.
It is the general experience that the policy cycles entail the risks of asset bubbles through corresponding bank credit bubbles. During the phase of policy relaxation (lower interest rates), credit expansion boosts the demand for assets (securities and property) and asset prices while the opposite happens during the policy tightening phase. In fact, in present financial markets, asset prices are instantly adjusted to actual movements of interest rates as well as their expectations.
The systemic
risk here is that, in the event the relaxing phase is longer, asset bubble peak
is so high that the tightening phase, if it is sharp, could cause significant
decline in asset prices causing a bubble burst. This has the potential of
financial crises causing an economy-wide recession. The financial crisis
2007/09 in developed countries is recognized as a similar asset bubble burst
with economic recession lasting for more than a decade created by the monetary policy cycle.
As such, the current speedier policy tightening also is expected to cause a
global recession with bear markets beginning the end of 2022.
As such, there is no evidence that the
monetary policy has ever ensured the price stability or any other objectives in
the medium to long-term and, therefore, such policy statements made by central
banks at present bear no credibility and public accountability.
8. Monetary policy in fact driven by fiscal
policy operations and emergence of modern monetary theory
Although central banks state that the monetary policy is implemented independently from the fiscal policy, it is in fact carried out in the financial space provided by fiscal deficits and borrowing (see a detailed article “Beware of Central Bank Independentists” available in this blog). The facts on monetary policy operations show that the money printing and open market operations are carried on the trade of government securities including the control of the yield curve whereas financial crises are resolved with the fiscal support. This is because central bank statues recognize only government securities as risk free for central bank assets.
In addition, the foreign currency reserve of central banks in
developing countries which is a major source of money printing and monetary
operations also is the financing side of the government foreign debt.
Therefore, as fiscal operations are not responsive to monetary policy and
interest rates, central banks routinely monitor the private sector credit
growth for the purpose of inflation control through private sector spending.
Therefore, the monetary policy in fact is an additional tax on the private
sector.
It is in this context that the concept
of the modern monetary theory has emerged as a challenge to the old
monetarists. The essence of this concept is that as the fiscal deficit is
actually financed by the monetary policy despite the policy rhetoric, the
fiscal policy must be planned for wider economic and human development through the mobilization of productive resources and capacity in the interest
of better living standards of the public. For this purpose, fiscal spending
through debt for infrastructure development inclusive of forest replanting and
environment protection to deal with climate changes and building social safety
nets is also considered in the wider macroeconomic interest.
Therefore, as long as the production
capacity is enhanced, the government does not have to worry about inflation and the continuation of fiscal deficits funded by money creation in the wider
public interest. In this model, tax is a better instrument to control the money stock than interest rate whose actual effects are not
known. Therefore, this new view proposes to carry on the monetary policy within the
fiscal policy.
However, old monetarists criticize
this concept by stating that this may be good for the countries with hard/international
currencies such as the US whereas developing countries will get to debt and
high inflation trap if this is implemented. If so, they must explain why Sri
Lanka has got into present level of catastrophic debt and galloping inflation
trap, despite so-called prudent fiscal and monetary policies in present models.
However, as fiscal authorities have been brain-washed by old monetarists on the inflation ghost, it has become extremely difficult to utilize the potential of the fiscal policy for the interest of the general public. Therefore, the mania of the fiscal space/deficit is haunting in the governments and, as a result, cutting the fiscal deficit in order to lower inflation through the reduced demand has been the objective of the governments world over.
Therefore, the governments mostly have the political interest of safeguarding the
interest of the layer of the politicians through the taxes although the public at large suffers poverty, hunger and
malnutrition in this science and knowledge driven world. The best example for
this is the present Sri Lanka, when looked at its parliament, Treasury, central bank and
the economic catastrophe confronted by the general public.
9. Policy rates determined highly arbitrarily
The general practice has been to change the policy rates by 25-50 basis points at a time over a fairly long period of time to ensure the gradual adaption of markets to the policy cycles. However, the change and the time of rate decisions are just guesses of the relevant policymaking individuals as they do not have any statistical or theoretical formula for determination of such rates with reference to their transmission channels and objectives. At certain times, higher changes in policy rates are announced.
For example, 75 basis points increase (to 1.75%) by the US Fed on June 15,
700 basis points increase (to 14.5%) by the Central Bank of Sri Lanka on April 8, 1,500
basis points increase (to 25%) by the Central Bank of Ukraine on June 3 and 12,000 basis
points increase (to 200%) by the Central Bank of Zimbabwe on June 27 are the recent changes. The change begins
from the current level of rates and the sequence is not comparable even within the
country.
However, researchers undertake numerous statistical
studies to establish the rationale of the policy rate sequence based on the macroeconomic
developments. For example, such researchers in many countries including Sri Lanka
attempt to establish whether the policy rates adjustments have been in line
with the Taylor Rule proposed by the John B. Taylor, Sandford Economics
Professor, for the US monetary policy whereas even the US Fed does not follow the
rule.
Some central bank officials tend to pretend that the monetary policy is conducted within the statistically designed macroeconomic models to mislead public that central banks are scientific. For example, Sri Lankan central bank by responding to a point presented in my paper article in October 2018 stated that I being a former Deputy Governor was not aware of the new model-based flexible inflation targeting monetary policy process in macroeconomic modelling and forecasting, which has made the process of monetary policy decision-making evidence based and forward looking. However, the central bank remained silent on my reply article to it.
Further, a retired central bank Assistant Governor
who had supervised the monetary policy answered a question raised by a private
counsel at a Presidential Inquiry Commission in 2017 that policy rates were derived
from a macroeconomic model. However, the truth is the monetary policy decisions
are just judgements although staff level officials may keep busy in office to test
economic models from time to time for their personal satisfaction.
A question arises why central banks
should adjust policy rates as markets themselves adjust interest rates in
response to inflation and inflation expectations and other risks. However, it is observed
that policy rates are revised in lags in line with market interest rates
movements. In addition, markets also adjust interest rates by expecting the phase of
the future policy rates. For example, US markets are pricing their financial products expecting the US Fed interest rates in the range of 3.0%-3.5% (neutral rates) at the current
phase whereas the range is being revised on new information. The Fed Chair recently stated that the monetary policy largely works through expectations of market participants.
Therefore, markets can function
without any guidance of policy interest rates. However, central banks adjust policy
rates in line with market rates to prevent increase in arbitrage profit by borrowing daily from central
banks at fixed rates and lending funds at higher market rates that adjust frequently.
10. Inflation
being the result of macroeconomic panic that requires wider fiscal intervention
Although monetarist believe inflation
as the demand driven phenomenon that could be the case for old tribal economic
societies, prices in present markets operating in modern economies with access to the
global economy and technology are determined by complex factors inclusive of
various expectations and speculations relating to both market operations and
geopolitical developments. In the modern world, even major commodity prices are
determined through financial contracts traded in derivate markets based on
sheer expectations without any reference to prevailing demand-supply conditions.
Therefore, market participants behave in herds driven by panic which is
generally seen in financial markets.
As such, all markets confront panic behaviours from time to time depending on expectations of market participants. The good example is how consumers and traders behave in commodity markets at present in Sri Lanka and how prices are moved up fast through speculations. Accordingly, similar to liquidity crunch created by contagious bank panics in the financial market/system, the present global rise in inflation is a result of contagious macroeconomic panic in goods and services market.
Therefore, the policy tightening will only
aggravate expectations and inflationary pressures. In this context, what is
required is the targeted fiscal intervention to stabilize the business confidence
among the market participants as done in the case of banking/financial crises.
Recommendation to
deal with present inflationary pressures with supply side distress
Most mainstream economists and
policymakers recommend monetary and fiscal policy tightening to tame the present
four-decade high inflationary pressures in the old style adopted in 1970s by
the US Fed known as the Volcker Moment. While central banks are already in the tightening
bandwagon, they pressurize the governments too to fall in line with deficit reduction to have wider
effects.
However, the present inflationary
pressures are not the ones known in old demand-supply equilibrium models as the
Corona pandemic and policy response to protect the societies from the pandemic are
extraordinary circumstances that have not been witnessed by economists and policymakers. Therefore, inflation driven by supply side bottlenecks caused by
the pandemic, the present war in Ukraine and connected market panic cannot be tamed
by the use of old demand driven macroeconomic models. As economics is not a science geared
for innovations and inventions in the interest of searching solutions to new
living problems, the fiscal authorities who run the governments for the general
public have to think new and find solutions to the current inflation problem.
Although fiscal and monetary stimuli offered
lavishly in 2020-2021 helped the recovery of socio-economic conditions to a
great extent, the existing supply bottlenecks and high inflationary pressures contagious
across the globe show that the recovery so far is only partial. Therefore, the present growth numbers from the slump at the pandemic are misleading. Further, the control
of inflation back to low numbers does not mean that exorbitantly high prices
and cost of living at present levels are not coming back to pre-pandemic
levels. Therefore, the inflation control in the current version is a sheer act
of misleading the public.
As such, what is necessary is a policy
package to restore the living conditions to the pre-pandemic levels. This
cannot be achieved without resolving the present supply side bottlenecks prevailing
globally where policy any tightening will only add to these bottlenecks and
aggravate the erosion of living standards though further increase in the cost
of production.
Therefore, what is prudent at this stage is to find ways to utilize existing relaxed monetary/financial conditions that remain idle to improve the supply side and production capacity continuously at least for the next decade in order to come out of the current macroeconomic mess. This is crucially vital for the countries like Sri Lanka in the bankruptcy and resulting political crisis. Therefore, the present mode of monetary tightening to tame inflation in the old monetarist style will be a historic policy mistake causing an unforgettable economic catastrophe of the public across the globe.
This is the reason why the Indonesian Central Bank Chief commented yesterday at a Bloomberg interview that he was in rush to tighten the policy in line with
other central banks as the central bank would be more interested in securing
the growth profile of the economy in priority at present.
in this perspective, the fiscal activism as suggested in the modern monetary theory would be of immense use to governments to find new solutions to evolving and soaring macroeconomic problems that pose historic danger to living standards that have been built over the past centuries with the help of science and technology.
The challenge is the inability of the policymaking officials to adjust to such new approaches and the incompetence of the elected political leadership to challenge the official network in the public interest.
A major hurdle in this exercise is the statutorily prescribed conceptual mandates of central banks to maintain price stability, economic stability, maximum employment, etc., through the monetary policy although the policy actions cannot be assessed against the performance of such mandates due to the difficulty in the testing of the policy transmission in modern dynamic economies with a large network of policymakers and markets that immensely contribute to same mandates.
Therefore, what is most practical at this stage is to rescind such macroeconomic stability mandates and require central banks to ensure the distribution of credit and finance to suit the needs of the economic sectors so that the fiscal policy can have the overriding stance on state policies and markets. This is vital because central banks are not the only game in the town to stabilize economies.
(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 be on Sri Lankan monetary policy model and the catastrophic economic crisis created by it.)
P Samarasiri
Former Deputy Governor, Central Bank of Sri Lanka
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