The CB Governor’s Inflation Control Myth - Let us find the truth

 

The CB Governor claims that the Central Bank has significantly tightened the monetary policy to control the rising inflationary pressures and to maintain the price stability in the medium to long-term. The monetary policy tightening has been the trend followed by almost all central banks in the world for same reason since the end last quarter of 2021 at different phases.

Therefore, the objective of this article is to prove why the CB Governor is incapable of controlling the present level of inflation and maintaining the price stability in the crisis-hit economy of Sri Lanka.

This 1^st part of the article presents the Governor’s views on present soaring inflation, description of inflationary sources in general, specific causes of high inflation in Sri Lanka and the Central Bank's monetary policy actions taken so far to tame the inflation.

Accordingly, the next part of the article will present why the Governor will definitely fail in controlling the inflation and maintaining economic and price stability in the present crisis-hit Sri Lankan economy.

The CB Governor’s Inflation Control Perspective

The Governor has expressed diverse views at various media interviews on the outlook of the inflationary pressures and policy actions.

Immediately after his appointment as the Governor on 8 April 2022, he blamed the two former CB Governors for excessive money printing under the Modern Monetary Theory (MMT) to fund a home-grown economic model as the cause of the rising inflation. 

At that time, he considered inflation as a domestic phenomenon attributable to the excessive money printing although key factors behind the inflation including global factors were well-known. He also predicted that the inflation would rise to 30% from the level of 18.7% reported at that time.

However, at later press releases and interviews, he has not only expanded the list of causes for the inflation to cover various domestic and global factors from both supply side and demand side but also revised the inflation forecast to 70%.

Some of his views expressed at CNBC and Ada Derana are highlighted below.

Views expressed at the CNBC Interview on 21 July 2022

• Inflation will be peaking somewhere in next couples of months because it has already happened. It will probably reach close to 70%, but with very tight monetary policy stance we are adopting since April 2022, it will start coming down over a period of time and we are very confident that it will turn around and it will be below around 20% in 12-month period.

• The current inflation is largely because of the shortages in the supplies and one-off adjustment of prices like depreciation of the currency and adjustment in fuel and food prices and adjustments in gas prices. One off adjustment in prices has basically pushed inflation to high territory and also partly because of previous monetary expansion and high printing of money and all these have lagged impact and it is a combination of demand driven plus largely now supply-side impact is basically causing inflation.

• Next two-three months’ inflation has already happened. So, what we can control as the Central Bank is the future inflation and managing inflation expectations going forward. That is why we are maintaining a very tight monetary policy and we are maintaining high interest rates.

• This is the reason why we want to curtail the inflation. That is the most important thing for the country, as you said, inflation is an enemy especially for the poor and they are going to suffer the most and if inflation goes beyond control like turning into hyper-inflation or 100%, then no one will be able to do any kind of businesses in Sri Lanka.

(see the interview - https://www.cnbc.com/video/2022/07/21/curtailing-inflation-is-most-important-thing-for-sri-lanka-central-bank.html)

Views expressed at Ada Derana Interview on 12 July 2022

• Interest rate hike is the policy instrument available to central banks to control inflation.

• Interest rate can control only the demand pulled inflation. According to the theory, interest rate should be above the inflation rate. If so, interest rate should be at 60%. However, there is no necessity to have such high interest rates.

• The most part of the present 54% inflation contains inflation arising from one-off events such as shortages of commodities, currency depreciation and oil and gas price increase. If electricity bill is raised, inflation will rise to 70%. That kind of inflation cannot be controlled by interest rates. Therefore, interest rates are kept only at certain level.

• When inflation has risen to 50%, 60%, 70%, etc., the prices will stay at that level or close to that level. Therefore, inflation will prevail at that level for about 12 months and then will fall to level of 20% or 35%. The inflation will rise and then definitely fall. That is why policy rates were raised.

• If interest rates are not raised, if inflation rises to 60%, 70% and above 100% or hyper-inflation position, then it will be extremely difficult to control the inflation. If so, the problem will be worse than the shortage of the dollar and nobody could do any business. In that event, currency unit will be abandoned, prices will rise daily, and wages will have to be raised. Therefore, this must be prevented.

• High interest rates will cause pain to businesses that are dependent on loans. However, if inflation rises above 100%, businesses cannot be carried on. Therefore, inflation must be first reduced, and interest rate have been raised for that.

• Further, low-income earners and the poor are the most affected by inflation. Middle income and high-income earners can manage inflation at some level. Inflation rising to 50%, 60% and 70% means that prices have doubled this year compared to the last year. Therefore, living standard of pensioners, fixed income earners and the poor has declined by half this year. These people are the majority population in the country and, therefore, the social unrest can increase further. Therefore, the first enemy is the inflation. Others are the next enemies.

See the interview - https://youtu.be/n5uvf6RUZuk

Meaning of Inflation and its Causes in Theory and Real World

The inflation in Macroeconomics is generally defined as the increase of the general price level in the economy as a result of the increase in the aggregate demand for goods and services above the aggregate supply of goods and services in the economy, i.e., aggregate demand greater than aggregate supply, between two time periods.

In some other macroeconomic analyses, inflation is the increase in the general price level at the aggregate demand greater than the economy’s potential output or supply. The potential output is the production at the full capacity of resources in active use. Therefore, the inflation at the time of the supply below the full capacity is not a concern as the supply side can improve to resolve the inflation over the time.

According to conventional monetarists, inflation is a monetary phenomenon when the aggregate demand rises through new money when the economy is at the full employment of resources.

Factors causing inflation are analyzed under various concepts.

• First is the most conventional concept of the imbalance between the aggregate demand for goods and services (AD) and aggregate supply (AS) in the economy. The general price of all goods and services (GP) is determined by the interaction of AD and AS. This is the application of the market mechanism in microeconomics. Accordingly, if the AD rises above the AS between two periods, which is known as the excess demand situation, the GP will rise until the balance is reached between the AD and AS. The continuous increase in the GP over a period is termed as inflation.

Accordingly, inflation can arise from various factors that cause restrictions in the AS and various factors that cause expansion in the AD. Therefore, some economists treat inflation as a result of the excess demand situation, irrespective of the underlying factors affecting AS or AD or both.

• Second is the monetarist version of excess demand which is caused by the monetary expansion. According to the monetarists, the AD is driven by the money stock in the economy as goods and services are priced and paid by the domestic monetary units. Therefore, any excess demand that causes inflation is the result of the increase in the money stock than the demand for money. Accordingly, central banks use this version of money-driven inflation concept to conduct the monetary policy. Therefore, the reason for raising the policy interest rates during inflationary periods is to lower the expansion of money and bank credit which will lead to curtail the AD and inflation in the economy.

• Third is the inflation caused by the increase in the cost of production/supply which is known as the cost-push inflation. The cost of production is a result of the forces operating in factor markets, i.e., labour, land, capital/credit and entrepreneurship, that determine factor prices or incomes, i.e., wage, rent, capital and profit, whose sum is the cost of production which is equal to the price of goods and services. Therefore, any factor that raises the cost of production results in increases in prices and inflation directly without affecting the volume/level of the AD and AS. In instances of inflation caused by a demand pull, factor prices also will rise causing inflation spirals. In modern monetary economies, interest rates is a factor price that quickly drives the cost of production as economies run on credit. In macroeconomics, the increase in factor prices or cost is nothing but the increase in the factor income and the AD in monetary terms that causes inflation.

• Fourth is the imported inflation in open economies through international trade in goods, services and factors. As a result, price increase or inflation prevailing in countries can easily spread among their trade partner countries. The direct increase in cost of production through imports is the main source of inflation in import-dependent economies. In open economies, key factors generally originating from the global economic changes that affect domestic costs and prices are energy and international commodity prices, foreign remittances, investments flows, exchange rates and geopolitical shocks.

• Fifth is the economic panic arising from continuous uncertainties prevailing in market-based economies as market participants tend to behave on expectations and speculations because the general price level is the aggregate result of all market forces. Therefore, in economic or political crisis situations, market players can have panic behaviour or economic panic like banking or financial market panics that cause significant changes in inflation until the panic disappears. Countries confronting political and governance crises such as Lebanon, Zimbabwe and Venezuela experience hyper-inflation mainly due to underlying economic panics. This is an inflation bubble that will prevail until underlying uncertainties dry up.
• Sixth is the factors arising from the nature and utilization of resources such as global warming, deforestation and environmental pollution that have cumulative and lasting impact on the supply side such as rise in cost of production, decline in productivity and restriction on the capacity and utilization. This has placed economies globally on a naturally caused inflationary path.

However, policymakers do not have data to identify and measure the GP, inflation and underlying factors relating to above concepts. Therefore, the general practice has been to estimate the inflation from the cost-of-living index or consumer price index (CPI) computed monthly for household spending based on a fixed basket of goods and services consumed in the recent past (base period). Accordingly, the percentage increase in the CPI between two months is used as the inflation rate.

Therefore, inflation analysis is mostly based on identification of factors that have caused changes in prices covered in the CPI rather than the changes in the GP caused by the demand-supply imbalances or cost of production in the economy. Therefore, analyses of inflation, causal factors and inflation forecasts are mostly statistical exercises on changes in the cost of living of average households rather than macroeconomic inflation analyses.

Another concept of inflation, core inflation, is nothing but the increase in a sub-index of the CPI basket that excludes food and energy items whose prices are considered to be seasonal. Central banks treat the core inflation as the inflation mostly responsive to the monetary policy. However, this is a misconception as the macroeconomic principles do not separate the impact of money stock/credit between prices of goods and services whereas macroeconomic inflation is about the rate of change in the GP in the economy.

Factors underlying soaring inflation in Sri Lanka

Although policymakers and economists talk about present inflationary pressures in respective countries, they all accept that present inflationary pressures have originated from global factors that are connected initially with the Corona pandemic since early 2020 and later added with the Russian invasion in Ukraine since 24 February 2022. Accordingly, inflation has spread across all countries at various scales depending on the exposure of respective countries to the global economy.

Disruptions or bottlenecks in global supply chains and sharp increases in energy and commodity prices are the major sources of inflation and its contagion across the world. However, until towards the end of third quarter 2021, central banks considered such inflationary pressures as transitory and expected to cool down when supply bottlenecks ease gradually over the time upon fully reopening of economies from Corona related lockdowns and restrictions. In contrast, the Russian-Ukraine war and western economic sanctions against Russia escalated global inflationary pressures.

Therefore, Sri Lankan inflation also has major links to these supply bottlenecks and global commodity price increases. However, Sri Lankan inflation has been steadily and fast soaring to hyper-inflation territory consequent to several domestic economic and political factors.

• First is the acute shortage of foreign currency in Sri Lanka. The depletion of the foreign currency reserve of the Central Bank and inflows on tourism, worker remittances and foreign currency loans to the government led to rigid import controls and shortages of essential imports in the country. This is also a supply bottleneck that has raised the domestic prices of imports that has led to chain effects on almost all prices in the import-dependent country.

• Second is the sharp currency depreciation since 7 March 2022. As a result, exchange rate for the US$ sharply rose by 85% within two months from Rs. 200 to Rs. 370 causing increases in the domestic prices of imports with a corresponding chain effect on all domestic prices which depend on imports as inputs and substitutes.

• Third is the removal of state-controlled prices on major food items such as rice, dhal and sugar. This is a statistical effect on inflation as controlled prices are used as market prices of these items in the CPI calculation despite the higher and volatile open market prices. Therefore, when price controls were removed, the CPI immediately rose due to the use of open market prices in the CPI.

• Fourth is the increase in fuel and gas prices. As the living blood of modern economies irrespective of their development stage is the energy, energy prices determine the health of economies. The major reason for the present global inflation is the significant increase in energy prices in global markets. In addition, the excessive currency depreciation stated above also resulted in a significant increase in energy prices in Sri Lanka.

• Fifth is the economic panic caused by excessive political instability and uncertainties. During such uncertain times, market participants behave irrationally under various expectations and speculations. As a result, prices are continuously pushed up by both buyers and sellers who speculate on bad information. When the country confronts long ques for fuel and gas and acute shortages of goods and services due to disrupted supply chains, a build-up of a general price bubble is a natural market phenomenon.

• Sixth is the reduction in the domestic production and trade due to disruption in economic activities caused by the economic and political instability. The decline in the production as measured by the real GDP of negative growth of 3.6% in 2020 could not be recouped in 2021 with a real GDP growth of 3.7%. The grave economic and political instability caused by shortages of imports and long ques for energy disrupted the economy so far in 2022 as reflected from the negative GDP growth of 1.6% in the first quarter which will not recover in the remaining part of the year.

• Seventh is the ultra-tight monetary policy followed with a hike of policy rates by 10% and SRR by 2% so far which has caused a significant increase in cost of production and business bankruptcies. This has contributed to inflation through both the increased cost of production and the reduced supply/production.

• Eight is the printing of money by the Central Bank and the increase in money supply through the banking system primarily for financing the fiscal deficit that may have fueled the AD. This is the usual political allegation like in many other countries. According to some economists as well as the CB Governor at the inception of his position, this is the primary cause of high inflation in Sri Lanka. However, author’s research shows that there has not been such a significant increase in money supply or AD to fuel this level of hyper-inflation (see next part of the article).

However, despite above context of inflation, the CB Governor picks some points in an ad hoc manner to present his analysis of Sri Lankan inflation.

Central Bank’s Inflation Control Policy Model and Recent Policy Actions

The monetary policy in Sri Lanka during the last two decades has primarily been used to keep the overnight inter-bank interest rates (OIIR) within the Central Bank policy interest rates which are applicable to overnight credit operations of the Central Bank with commercial banks. Accordingly, Standing Deposit Facility Rate (SDFR, 14.5% at present) and Standing Lending Facility Rate (SLFR, 15.5% at present) are such policy rates. Therefore, the objective of policy rates is to maintain the inter-bank liquidity level so that the OIIR prevail in the policy rates corridor. In addition, Statutory Reserve Ratio (SRR) (4% at present) also is used to finetune the liquidity in the banking sector for the above purpose.

The Central Bank states that this monetary policy is adopted to keep the actual inflation of the country within the inflation target of 4%-6% set by the Central Bank. Accordingly, the Central Bank raises policy rates when the inflation rises or is expected to rise above the inflation target and vice versa.

Accordingly, the Central Bank has raised policy rates five times in total of 10% since the middle of August 2021 from 4.5%-5.5% to 14.5%-15.5% so far. Further, the SRR has been increased by 2% to 4% in August 2021 as part of supporting the policy tightening by mopping up of nearly Rs. 120 bn from the banking system.

However, inflation as measured by the CPI also has risen much faster from 5.7% in July 2021 (month before commencing the policy tightening) to 60.8% in July 2022, i.e., 10 times increase in the monthly cost of living during the past 12 months compared to previous 12 months ending July 2021 (the increase in the index from 143.1 to 230.1, based on the index 100 in 2013). 

Accordingly, the present monthly cost of living is an increase of 130% from that in 2013. This means that monthly spending of an average household on the CPI basket has increased from Rs. 60,364.74 in 2013 to Rs. 138,899.27 in July 2022 as per statistics of the Census and Statistics. This itself shows that the Central Bank has miserably failed in maintaining the economic and price stability, despite its mandate in the Monetary Law Act and own rhetoric of keeping inflation in 4%-6% target.

Date	Monetary Policy Tightening	Inflation, %
19.08.2021	Policy rates by 0.50% to 5.0% and 6.0% and SRR by 2% to 4%	5.7
19.01.2022	Policy rates by 0.50% to 5.5% and 6.5%	12.1
03.03.2022	Policy rates by 1% to 6.5% and 7.5%	15.1
08.04.2022	Policy rates by 7% to 13.5% and 14.5%	18.7
07.07.2022	Policy rates by 1% to 14.5% and 15.5%	54.6

The Governor predicts that the inflation would rise to 70% consequent to hike in electricity rates, stay at that level or close to that level for about next 12 months and then fall to a level of 20% or 35%. He is sure of this rise and fall of the inflation during next 12 months.

However, this is only a conceptual prediction as the monetary policy is unable to resolve all factors underlying inflation as stated above. His prediction for inflation falling to 20%-35% level after 12 months means that the inflation driven by the past monetary expansion through the AD should be around 35%-50% because the Central Bank monetary policy has a handle only to control demand-driven part of inflation.

Therefore, next article will present why the Governor’s new monetary policy tightening hypothesis would fail to arrest the soaring inflation in Sri Lanka. The Governor himself has admitted that present kind of inflation cannot be controlled by interest rates, i.e., monetary policy. 

Therefore, he has started preaching various economic sermons of his wish and belief to attract general public by imaging him as a national hero in clean, white clothes with the objective of enjoying his full term of office whether the economy is dead or alive, not second to the attitude of the country's many political leaders.

(To be continued)

(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.)

 

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)