The CB Governor’s Failure to Control Inflation - Is he accountable for macroeconomic losses?

 

The last article released on 16 August 2022 (and the article released on 7^th July) presented economic interpretations for the inflation, key factors underlying the galloping inflation in Sri Lanka and monetary policy actions taken by the Central Bank to control the inflation along with the CB Governor’s views on inflation outlook.

The objective of this article is to establish that the present model of the Sri Lankan monetary policy cannot control current inflationary pressures although macroeconomic theory suggests the ability of the monetary policy tightening to control inflation by curtailing the growth of aggregate demand (AD) in the economy over a time period as AD is driven by money in circulation. 

It is in this theoretical context that central banks have been assigned with statutory mandates of price stability. Therefore, almost all central banks have been tightening monetary policies competitively by primarily raising policy interest rates since the beginning of this year to control inflationary pressures rising across the globe.

Such inflationary pressures are rising towards an annual inflation of 10% in terms of consumer price indices (CPI) in developed market economies from the levels below 2% that has prevailed in the last decade and are considered as four decades high. Sri Lankan inflation also is an extension of the global inflation further fueled by several domestic factors at historic high and rising to hyper-inflation territory among few countries in the world such as Zimbabwe, Venezuela, Turkey and Lebanon.

CB Governor’s views on inflation outlook and his inability to control inflation

On 8 April, he bravely criticized that Sri Lankan inflation was a result of the excessive money printing carried out by the two former CB Governors under the MMT based home-grown economic model and promised that he would professionally and independently cut down money printing and control inflation. The inflation at that time (in March) was 18.7% with his forecast of 30% in next few months.

However, during the past four months with additional monetary tightening of 800 basis points increase in policy interest rates to 14.5% and 15.5%, the inflation has risen to 60.8% in July.

His inflation forecast also has risen from the initial 30% to 50%, 60%, 70%, etc., for about next 12 months and then fall back to level of 20% or 35%. However, the forecast published in the monetary policy press release in July was about 65%-85% in the fourth quarter 2022 .

In contrast, at the monetary policy press conference held on 18 August 2022, the Governor reduced his inflation forecast of the peak at 65% in September even with the impact of the increase in electricity rates and fall thereafter (see video below).

Further, he has extended the list of causes for high inflation from the excessive money printing in April to several domestic factors such as supply side bottlenecks, currency depreciation, shortage of imports and increase in energy prices. Accordingly, his inflation control story has been highly shaky and unreliable.

Therefore, it is clear that his policy interest rates-based monetary policy model has already failed to arrest rising inflationary pressures.

• First, inflation rate has more than tripled as indicated above despite the hikes in policy interest rates.

• Second, his inflation forecast also has been more than doubled. However, he has not given the forecasting model or underlying assumptions. Although a forecasting diagram was given in the monetary policy press release issued on 07 July 2022, it is highly unofficial and unprofessional as it has stated that the forecast was neither a promise nor a commitment (see the Diagram below).

• Third, he himself has admitted at Ada Derana media interview held on 12 July 2022 that this kind of inflation could not be controlled by interest rates because interest rates can control only the demand pulled inflation. However, he has neither indicated how demand pulled inflation is separated from the inflation nor laid down the mechanism of interest rates to control the demand pulled inflation.

• Fourth, instead of his promise to curtail money printing to control inflation, he accelerated money printing with a new system for the direct purchase of Treasury bills by the Central Bank.

• Fifth, the Governor has stated that, according to the theory, interest rates should be above the inflation rate and, if so, interest rates should be at 60% and there is no necessity to have such high interest rates. Therefore, his theoretical monetary policy is contrasted by himself as he deviates arbitrarily from the theory. None of the central banks in the world has conducted the monetary policy to maintain positive real interest rates in the past few decades and, therefore, his statement on the theory is meaningless.

However, as usual, he may give unexpected post-events such as political instability as excuses for his inability to control inflation. His promise as well as the statutory duty are to control inflation and maintain the price stability through the monetary policy, irrespective of the underlying factors whatsoever. The Monetary Law Act (MLA) or the macroeconomic theory does not differentiate between these factors for the monetary policy. Therefore, offering numerous views or management-based motivational/inspirational talks on suffering from inflation and emerging back through hard work and tolerance is not of part of his inflation control mandate and policy instruments.

It is likely that the CB Governor might state very soon that the cost-of-living impact of the current inflationary pressures is the responsibility of the fiscal policy as the monetary policy is to maintain price stability in the medium to long-term. This means that he has the time to enjoy his independent printing job in the state money printing press for his full term of office of 6 years and probably ask for another term of office to cover a part of the long-term he needs to control inflation and bring back the price stability.

He has already stated at a CNBC interview on 21 July 2022 that what the Central Bank can control is the future inflation and managing inflation expectations going forward.  Therefore, he has already paved a cunning way out for his selfish strategy. Therefore, he can rest in the job until inflation expectations come down to his inflation target around 4%-6%. As his present inflation forecast is 20%-35% after next 12 months, he has enough time for his personal targets.

Further, at the monetary policy press conference held on 18 July 2022, the Governor stated that policy interest rates were kept unchanged as favorable economic signs were seen that inflation would ease in the future. He attempted to draw a rosy picture on the economy as a result of favourable impact of Central Bank policies implemented recently. His statement that essential imports such as fuel now can be financed from foreign currency inflows without short-term foreign loans is surprised, given the country's bankruptcy that will last years to come. However, the media reported his new monetary policy decision as a favour and blessed news offered by the Governor to the nation.

However, the truth is that these are just ad hoc views, given the crisis status and global recession threat looming now consequent to global sugar-rush monetary policy tightening. As policy interest rates were raised by 1% at the last meeting held on 7 July 2022, the Central Bank has no ability to implement another rate hike, given government securities yield rates jumped to around 30% from the level of 14%-15% prior to the policy tightening in April 2022 which has been causing a severe credit crunch and exorbitant increase in cost of funds in the economy.

Other Reasons why the CB Governor fails in controlling inflation and maintaining price stability

In dynamic open economies, the monetary policy is just another policy carried out under conventional concepts without any proof of the policy efficacy on controlling inflation and maintaining price stability established from the real-world data as advocated by central banks and monetary economists. In that background, major reasons why Sri Lankan Central Bank will fail controlling inflation are presented below.

Poor transmission of overnight inter-bank rates

Present policy interest rates-based monetary policy model expects that the changes in overnight inter-bank interest rates would cause changes in credit delivery and AD to maintain inflation in the target set by the Central Bank. That is not true as the country’s actual inflation now has risen to 60.8% beyond the control of the monetary policy despite the continuous monetary tightening since mid-August 2021 with the increase in policy interest rates by 10% and SRR by 2%. 

Given the dynamics of credit and AD in the economy, there is no empirical research to make the public believe that policy interest rates or overnight inter-bank interest rates would drive bank credit and AD to keep the inflation as the Central Bank wishes. Therebefore, central banks only present hypotheses on the transmission of policy interest rates to AD and inflation.

Misunderstood inflation

The monetary policy in macroeconomics is designed to maintain the general price stability by minimizing the imbalances between AD and AS which are determined by various factors (see the video below). 

Therefore, the monetary policy is a discretionary action to stabilize the general price level. As such, monetary policy is a credit market control within the powers of central banks. 

However, the inflation indicator adopted by central banks world over is the rate of change in the monthly cost-of-living index known as CPI which represents movements of household spending due to changes in market prices in response to various factors including seasonal factors. Central banks also analyze inflation dynamics and forecasts based on movements of prices covered in the CPI. However, the purpose of the CPI is to measure the movements of monthly cost of living consequent to changes market prices of a fixed consumer basket of average households.

Therefore, CPI inflation is not an appropriate inflation indicator for driving the monetary policy by focusing on imbalances between AD and AS. As such, it is difficult to identify the overnight interest rate-based monetary transmission on the CPI.

Further, other than ad hoc views, central banks do not have reliable data to measure AD and AS imbalances whereas AD is mostly estimated ex-post from AS profile. However, what is necessary for the monetary policy is to assess the trend or the movements of the AD independently from the AS. 

Further, as presented in macroeconomics, monetary policy has an impact on both AD and AS through credit flows in modern monetary economies. For example, investment financing credit directly improves the production capacity and raises the AS. Therefore, central banks run after a wrong notion of inflation against relevant economic principles.

Misleading inflation statistics on CPI numbers

In monetary policy analyses, annual inflation numbers are presented in two forms. The first is the year-on-year inflation and the other is the annual average inflation. The first is the percentage increase of the CPI in any month from the CPI of the corresponding month in the previous year, for example, inflation in July this year is 60.8% from July last year (i.e., the increase of the CPI from 143.1 to 230.1).

The other is the percentage increase of the average CPI for past 12 months from the average CPI of the corresponding 12 months of the last year. For example, the annual average inflation rate in July this year is 23.1% (i.e., the increase of the average CPI from 138.7 in July 2021 to 170.7 in July 2022). In addition, there are several types of price indices calculated for same purpose, for example, National Consumer Price Index, Producer Price Index, Producer Farmgate Price Index and Wholesale Price Index. The misleading occurs in many ways.

• First, central banks use either of measures to show a lower inflation rate in their favour.

• Second, as inflation is presented as a percentage increase of the CPI, the inflation figure is largely determined by the base effect which is not a market price effect. The base effect is a statistical error. For example, when the CPI rises from low index levels, inflation tends to rise faster due to the base effect. In contrast, when the CPI rises from high index levels, inflation tends to be lower due to same base effect. The reason why inflation forecast tends to fall after the peak is this base effect. Therefore, targeting inflation at a particular rate such as 2% in developed countries or 4%-6% in Sri Lanka does not mean the stability of prices in general around a certain level as it is only a statistical exercise.

Therefore, the recommendation that a specific CPI number be targeted in the monetary policy for accountability is not accepted by central banks as their policy rhetoric is exposed. Further, CPI change is not reflective of the macroeconomic inflation determined by the demand-supply imbalances in the economy that the monetary policy is mandated to sort out along with fiscal instruments.

• Third, brave talks and forecast of inflation falling in the future do not mean that the cost of production and cost of consumption will fall back to previous levels. What it means is that the increase in costs will fall in the forecasting period but the cost will rise as long as the CPI rises. For example, each index point increase in Sri Lankan CPI is an increase of about Rs. 321.43 in monthly cost of living of a household. 

Therefore, the monetary policy cannot bring consumer prices or price stability back to previous levels. Accordingly, inflation getting back to the target does not mean anything to the general public other than intellectual pleasure of central bank economists to state that inflation is low due to prudent monetary policies. However, if people are to economically benefit, prices in general in the economy should decline to pre-inflation levels.

• Fourth, the decline in household real income consequent to rising prices also leads the households to cut the consumption volumes which is known as Pigou effect that leads markets themselves to control prices. Everybody knows that low and middle-income households have cut down their consumption of almost all goods and services. However, the CPI is computed on fixed consumption quantities used in the base year basket. Therefore, CPI and inflation numbers are over-estimated and unreliable because the actual CPI and cost of living should be lower if the actual household consumption in the current month is considered in the CPI calculation.

• Fifth, the concept of core inflation used by all central banks in the monetary policies is a meaningless myth. The core inflation is the change in a sub-index of the CPI basket that excludes food and energy prices. Central banks treat the core inflation as the inflation mostly responsive to the monetary policy actions. Therefore, this is a misconception as the macroeconomic principles do not differentiate the impact of money stock, interest rates or monetary policy between the prices of goods and services. Also, central banks do not have empirical research on the responsiveness of the prices in the core CPI to changes in policy interest rates. The core inflation in Sri Lanka in July 2022 is 44.3% on annual basis and 16.7% on annual average basis as compared to 13.0% and 6.5%, respectively, in March 2022. Therefore, these inflation numbers are meaningless statistics in macroeconomics.

This core inflation in fact is a political inflation computed by two economists at the US Treasury in 1970s with a motive to show a lower inflation as against high inflation reported in the US in 1970s due to rising energy prices. Once the heavy-weighted food and energy items are excluded from the CPI, the remaining is only a minor set of services and manufactured goods in the CPI basket. 

Therefore, I am at a loss to understand why professional economists in modern central banks deceive themselves by talking about the core inflation. Although the core inflation is considered as the inflation responding to the monetary policy, the fact that central banks do not target the core inflation in the monetary policy discredits the concept by themselves.

• Sixth is the direct control of the CPI by fiscal instruments such as grants, indirect taxes, subsidized prices, price controls and free supply of selected goods and services to keep the cost of living eased. Therefore, the CPI and inflation are practically determined by fiscal policy actions rather than monetary policy actions such as policy interest rates. That is why governments act to control the cost of living without waiting for monetary policy actions in order to protect the public popularity in the government when consumer prices and CPI are rising. Therefore, nobody blames the Central Bank for rising cost of living and inflation. However, while governments implementing fiscal relief measures to reduce the cost of living, they also blame central banks for the inflation to find a scapegoat. Further, when the inflation is eased by fiscal relief measures, central banks call victory in controlling inflation through prudent monetary policy.

• Seventh, the CPI could be an inflation indicator in primitive economies with limited production and consumption. However, economic activities in modern monetary economies with global access are so complex and dynamic that CPI is not appropriate for assessing the macroeconomic inflation although it may represent movements of basic cost of living of average households for wage negotiations.

Therefore, central bank monetary policy and rhetoric in the current policy model are meaningless statistical exercises. Accordingly, talks on erosion of living standards or financial wealth by discounting their values by the annual inflation rate are meaningless and may cause unnecessary panics among the institutions and households. If those are meaningful, we will not have an economy operating today. 

The value of financial wealth and assets depends on their market prices whose movements are different from the inflation or CPI and depends on the investor trust while they are held for investment purposes based on returns, safety, liquidity and solvency. For example, high interest rates reduce the market value of financial investments where asset price bursts also could happen. 

In that context, marked-to-market value of government securities has caused significant losses to old investors. However, the value will rise back when interest rates rise. Further, if the market value deflated by inflation is considered, investments in government securities will not have a real value. 

Therefore, political leaders must be very careful when they make such questionable economic talks by listening to the Central Bank’s conceptual analyses.

Non-availability of instruments to anchor inflation expectations

The Sri Lankan central bank like all other central banks states that the monetary policy is intended to anchor or control inflation expectations of the public towards the inflation target (4%-6%) in the monetary policy. They say that the public has the trust in the central banks in controlling the inflation and, therefore, the public tends to reduce inflation expectations towards the target whenever central banks act in the monetary policy.

This is only a meaningless statement because, except money dealers and large business firms, the majority public is not aware of anything on such technical monetary policies. If the public has the trust in the ability of central banks in the inflation control, present inflation across the globe cannot rise to such historically high levels. 

Further, expectations are the contemporary mental conditions of the public and central banks do not have economic psychiatrics or psychiatric instruments to control such inflation expectations to be around their inflation targets. In fact, what central banks present in their policy communications are not understood by the general public and those are made to satisfy the relevant monetary policy economists.

Inability of the monetary policy to resolve Sri Lankan present inflation factors

As presented in the part 1 of this article, supply side bottlenecks including global supply chain disruptions, economic or supply side recession (1.6% in the first quarter and 8% expected in this year), hikes in global energy prices and shortages of imports and excessive currency depreciation due to the acute shortage of foreign currency in the country and the non-existing foreign currency reserve of the Central Bank are the major reasons attributing to present soaring inflation as measured by the CPI.

Therefore, present inflation can be resolved by the Central Bank only if its policy interest rates and present monetary policy model are able to ease those factors to pre-crisis/inflation level. It is common sense that the present monetary policy model has no instruments for that. At least, if the Governor is able to build back the Central Bank foreign currency reserve to be around US$ 8 bn and appreciate the currency to Rs. 230 per US$ through the monetary policy, the economy will come out of the crisis through improved supply conditions and reduced prices.

It is globally accepted that current global inflationary pressures are mostly a supply side phenomenon and, therefore, standard version of the overnight interest rates-based monetary policy cannot tame such inflationary pressures. However, central banks state that they only have interest rate instrument to control the demand side where it is the duty of fiscal authorities to resolve supply side problems. Governments tend to use fiscal instruments to ease the cost-of-living pressures based on the CPI and other productivity issues. For example, the US passed a new legislation “Inflation Reduction Act” on 16 August and the President requested oil companies to reduce fuel prices which are the prime cause of the present inflation wave. Therefore, monetary policy is clearly a misfit in the current inflation fight.

Excessive money printing to fund the government and money dealers

Although the CB Governor stated on 8 April 2022 that he would control the inflation by reducing the money printing independently, he in fact has increased money printing not only by buying Treasury bills outside weekly auctions but also by introducing a new system of issuing Treasury bills directly to Central Bank whenever the Treasury requires funds.

Accordingly, the Central Bank from 8 April 2022 to 19 August 2022 under the present Governor has printed money in net terms amounting to Rs. 380.2 bn to fund weekly Treasury bill auctions for keeping the yield rates controlled around 30%. Further, he has printed about Rs. 390.1 bn so far under the Central bank’s new Treasury bill purchase system since 6^th May. Therefore, this printing (Rs. 770.4 bn) is nearly 68.5% of money printed by the Central Bank under the two former Governors from 01 January 2021 to whom the present Governor blamed for the money printing and inflation.

In addition, daily money printing carried out to fund bank dealers over night gas increased to Rs. 780 bn on 19 July from the level of Rs. 605 bn reported on 7^th April, the day prior to his first day of office.

Therefore, if his money printing-based inflation argument is correct, the subsequent hike in inflation from 18.7% in March 2022 to 60.8% in July 2022 with a forecast of further increase to 65%-70% in next few months despite 8% policy rates hike by him alone is largely a direct result of his new money printing operation. 

As such, the Governor himself has contradicted with his policies and views and, therefore, the inflation cannot fall to 20%-35% levels after next September or next 12 months as he now predicts. This clearly shows that the Governor is not publicly trustworthy for the post.

Erroneous monetary statistics

Growth rates of money supply and domestic credit are the key monetary statistics that the Central Bank monitors to figure out the underlying trend of the AD. As at end of June 2022, annual growth rates of money supply (M2b) and domestic credit are 17.1% and 24.8%, respectively.

However, the impact of the currency depreciation (the increase of the exchange rate by 80%) from 7 March 2022 has led to a significant artificial increase in the monetary and credit growth due to the valuation effect on foreign currency denominated credit and deposits. This valuation is only a book entry and has no impact on AD or actual monetary conditions in the economy.

Therefore, if the valuation effect in bank books is removed, the monetary and credit growth would be very marginal, given the crisis-driven AD and AS conditions and severe shortage of funds in the economy. Further, as monetary statistics also are used as annual growth rates, base effect causes monetary growth rates to be misleading. Therefore, the monetary policy tightening at present has no economic rationale.

Demand pulled inflation invalid now

Although money supply and domestic credit have grown in nominal terms as shown above, the real AD driven by the money supply is the real money supply growth. Accordingly, if the money supply is deflated by the CPI (100 in June 2021), the real money supply in June 2022 has declined by 24.3%. If the currency depreciation effect on the money supply is removed, the decline will be higher.

Therefore, the decline in real money supply is a reliable indicator for the decline in the AD from June 2021 to June 2022 as the Central Bank does not publish statistics on the movements of the real demand. As such, the argument for demand pulled inflation is incorrect. 

When both the real money supply and real GDP decline, there is no possibility for excess demand pressure in the economy from the macroeconomic point of view. Therefore, the present monetary tightening hypothesis in Sri Lanka is not justifiable and it has caused significant economic instabilities through shortages of funds and increased cost of funds.

Monetary policy being a blunt instrument causing business cycles and asset bubbles

Central banks change policy rates arbitrarily by various basis points, generally 25-50, in two phases by judging at the inflation trend. In one phase, rates are raised stepwise with expectation to reduce inflation towards the target and then rates are cut in the next phase to promote the economic growth already affected by high interest rates. As a result, economies confront with policy rates cycles and business cycles. 

As central banks are not aware of the length of the cycles, economies always confront uncertainties and business cycles caused by the monetary policies. In some instances of policy tightening after a long period of relaxed policy phase, financial crises also hit, for example, the financial crisis in developed countries in 2007/09.

The present sugar-rush phase of monetary tightening by central banks is expected to cause a severe economic recession globally by end of this year where the US already has touched the technical recession. Therefore, the monetary policy or interest rate in the present model is considered as a blunt tool as it always causes a trade-off between inflation and economic growth. 

Developed countries can manage such trade-offs because of the fiscal policy safeguards available. For example, unemployment during the recession caused by the policy tightening is handled by fiscal grants provided to unemployed people. However, the policy tightening in Sri Lanka and developing countries is an economically and socially painful exercise as the provision of such fiscal supports is limited by fiscal constraints.

Like in foreign trade policies, monetary policies also are carried out competitively to protect foreign capital flows arising from interest differentials and exchange rate movements between the countries. This primarily happens when the US Fed raises its policy interest rate as the US Dollar is the major global reserve currency. As foreign capital starts flowing back to the US for high returns, other central banks also raise interest rates to discourage capital outflows from their countries. The opposite happens when the US Fed cuts interest rates. In such instances, monetary policy is not a direct instrument for inflation or GDP growth as central banks state, but an instrument for managing capital flows for BOP purposes.

As such, the monetary policy is appropriate for finetuning economic and financial volatilities during normal periods, and it cannot deal with crises which are generally resolved by government policies.

Non-availability of clear relationship between monetary statistics and macroeconomic outcomes

Although central banks talk about managing inflation and economic growth through the policy interest rates, such stories are only conceptual or textbook presentations under various assumptions as there is not empirical research to establish relationships between interest rates and macroeconomic outcomes. In dynamic economies with access to the global economy, economic outcomes are determined by various market forces and fiscal policy instruments. Therefore, in many developing countries like Sri Lanka, monetary policy tools are often used to address sectoral issues such as capital flows and trade deficits because interest rate is the prime instrument used for all purposes.

However, in present crisis in Sri Lanka with debt default implemented by the present CB Governor, Sri Lankan policy interest rates have no role in attracting foreign capital or seeking a favourable BOP position. Therefore, the monetary policy in the current context is a clear detriment to the Sri Lankan economy as high interest rates raise the domestic public debt stock and cause bankruptcies in businesses and households consequent to the unbearable increase in cost of funds while the economy is expected to contract by nearly 8% in this years.

Automatic adjustment of market interest rates to risk factors including inflation

It is well known that market participants, especially money and capital market dealers and investors, revise interest rates to capture different levels of inflation expectations so that the real interest rates, i.e., market interest rate less expected inflation for the investment period, are largely stable. Therefore, markets do not need specific changes in policy interest rates to deal with inflation risks. 

Central banks generally follow market interest rates with lags, especially the yield curve or the pattern of Treasury securities yield rates. That is the reason why the Central Bank controls Treasury bill yield rates on weekly basis by purchasing Treasury bills through money printing supported by reintroduced private placement window which facilitates their friendly dealers to avoid bidding risks.

The present Governor in fact justified massive scale of private placements of bonds carried out in 2008-2014 period as a powerful instrument used to control interest rates. It is simply an unlawful market manipulation against basic economic principles. Central banks also conduct OMO in government securities to regulate yield rates in order to guide the private market interest rates. 

Therefore, only reason central banks hike policy interests are to prevent arbitrage profit of bank money dealers through borrowing at low interest rates from the central bank and investing such funds at higher market rates frequently adjusted to inflation expectations. Therefore, the monetary policy is largely a policy facility for arbitraging activities of money and financial market dealers.

Policy statements are meaningless economic stories with undefined words

Monetary policy statements and press briefings are meaningless rhetoric of the Central Bank as they contain diverse economic terms to satisfy those economists. Some statements are clearly unacceptable. For example, the Governor at the last press conference stated that this year’s negative growth is expected to rise to 8% from the earlier forecast of negative 7.5% and this increased economic contraction is good as the recovery can be made faster. This is again due to the base effect because the growth of a contracted economy will be higher due to lower GDP base.

In all policy statements, policy transmission times are mentioned as near-term, medium-term and long-term which have no practical or identified time durations. For example, the present Governor talks about maintaining the price stability in the medium to long-term. However, these terms never start or end although the Governor, Monetary Board members and monetary policy economists frequently change. As such, policy impact assessment does not have an accountable time base.

Violation of the MLA by focusing on the CPI inflation

The present monetary policy model is a non-compliance with the monetary policy mandate and instruments laid down in the MLA. The MLA version of the monetary policy is a consolidation of domestic and international monetary conditions to achieve economic and price stability and financial system stability of the economy. In fact, no MLA provisions are available to define inflation or target inflation for the monetary policy.

As such, the current economic crisis is a result of the MLA violations, primarily for not being able to manage an international reserve and exchange rate stability in compliance with the relevant provisions of the MLA.

Monetary tightening inappropriate for countries in economic/financial crises

Sri Lankan economy is clearly in severe depression due to shortages of essential imports and supply disruptions since 2020 as reflected from a negative real GDP growth of 3.6% in 2020 which as not recovered by the GDP growth of 3.7% in 2021, a negative growth of 1.6% in the first quarter 2022 and a negative growth of 8% expected in 2022. Therefore, there is a significant excess capacity in the economy. As shown above, the real demand also has contracted. However, the Central Bank has tightened the monetary policy to historically high levels for controlling misunderstood inflationary pressures.

Therefore, if basic economic principles are followed, the monetary policy relaxation is the correct policy stance required for depressed economies. As such, present monetary tightening in Sri Lanka would no doubt cause a long-lasting bankruptcy in the economy. It is difficult to understand why the Central Bank tightens the monetary policy knowingly that there would be a severe contraction in output, income and employment in already crisis-hit economy for controlling of statistical inflation whereas the inflation itself is a result of supply side disruptions and downfall.

Financial systemic risk underlying the present monetary policy model

In the present model, the money printing or the supply of reserve money is determined by very short-term credit granted by the Central Bank to banks and government, for example, overnight credit to banks and mostly 90-day Treasury bills. Therefore, money and credit system naturally confronts a very high liquidity risk as banks have to transform very short-term funds to medium and long-term credit.

Instead, if central bank lending takes longer term, financial system will have long-term input money for credit operations with less liquidity risks. Therefore, central banks in developed countries such as the Fed and ECB tend to hold more of medium and long-term government securities in their OMO portfolios while providing overnight funds to banks.

Accordingly, it is common sense that the present overnight credit-based monetary base in Sri Lanka cannot provide a medium and long-term development friendly credit delivery system. Therefore, both financial system and recovery of the economy run significant risks under the present monetary policy model.

Final Comment

There is no controversy over the present economic crisis as the direct result of the Central Bank’s failure in monetary management of the economy including the foreign currency reserve and exchange rate stability as provided for in the MLA. In addition, further deepening of the crisis as a result of raising interest rates by 8% so far since 8 April 2022 and defaulting foreign debt on 12 April 2022 by the present Governor is also undisputable. 

As presented above, present monetary policy tightening model is also a failure to arrest soaring inflation of 60.8% at present which is expected to rise further in coming months at a severe macroeconomic cost to the general public. Brave talks of the CB Governor on the fondly IMF programme and debt restructuring seem to be withering with targets after targets.

Further, it is accepted that present global wave of inflationary pressure is a supply side phenomenon and monetary policy tightening will have dampening effects on the economies and general public across the globe.

Therefore, it is the public responsibility of the President and Finance Minister to question the suitability of the members of the Monetary Board under section 16 of the MLA and to direct the Monetary Board under section 116(2) of the MLA to discontinue the present policy model and to adopt a monetary policy in accordance with the opinion of the government for the greatest advantages of people. Sri Lanka needs such bold decisions if the government wishes to rescue the economy and public from the present crisis.

Otherwise, the President and Finance Minister being silent in the current monetary policy mess will also be responsible for the policy failure of the Central Bank as the silence is tantamount to the policy concurrence.

However, as the government does not seem to have the macroeconomic policy expertise to resist the Central Bank policy models and hypotheses, the general public has to believe religious teaching of KARMA and wait until the KARMA of the majority Sri Lankan people ends upon the suffering through poverty, hunger and unemployment so that economic sermons preached by the CB Governor for his inflation to fall and the economy to recover with price stability from the present crisis realize in the medium to long term.

Anyhow, when current uncertainties are eased with political stability, the present excessive price bubble also will shrink resulting in falling increases in the CPI where the CB Governor as usual will start a brave media campaign to deceive the public and political leaders by preaching that his prudent monetary policy has tamed the inflation and the economy now can recover with price stability and government's policy reforms in the medium to long-term. 

However, as this is only a numbering game of the Central Bank as usual, the real economy and public will struggle in the crisis for decades to come.

(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 economic disruptions and shocks.)

 

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)