Global Club of Flawed Monetarism - Why should we leave it?

 

The objective of this article is to express some thoughts on how world monetary policies are flawed and why emerging countries in development struggle should seek alterative strategies for aligning their financial resources to development needs.

A snapshot of present global monetary policy framework

The present global monetary system is driven by global reserve currencies led by the US Dollar and global capital flows based on interest rates of reserve currencies. The IMF and World Bank remain as the system’s supervisor with the lender of last resort facilities (LOLR) and surveillance funded and governed by their rich members led by the US.

This is the result of the global monetary system created by the Bretton Woods agreement in 1944 which linked the exchange rates of currencies to the USD in place of the gold standard. Later, IMF and World Bank established on this agreement promoted global private capital and financial markets which are now driven by the US monetary policy. As a result, monetary systems of all countries are now effectively built on US Dollar, US interest rates and US Dollar-based private capital flows.

In this system, all countries follow the US monetary policy model and policy cycles. The present policy model is the inter-bank overnight interest rates target aimed at controlling demand-driven inflation at preferred targets (2% in developed countries). Therefore, whenever the Fed adjusts it policy interest rate, i.e., fed funds rate target, all central banks led by Bank of England, European Central Bank and other central banks with reserve currencies follow suit with the objective of maintaining their interest rates differentials and protecting foreign capital.

As a result, monetary policies of developing countries have sacrificed the domestic policy independence to the US economic interests. The system is blessed by IMF and World Bank through their surveillance and consultation and the network of their agents stationed in country central banks and finance ministries. 

In the event of so-called fundamental BOP problems arising from such monetary policies and resulting disruptions in trade and investment flows, they provide conditional LOLR known as bailouts negotiated by their agents. Accordingly, the US economy and its currency are protected across the world, thanks to the IMF-World Bank global surveillance network.

Fed, BoE and ECB hiking interest rates at the dawn of the new year

Three global central banks led by the Fed are on the verge of disrupting the developing world by sugar high tightening of monetary policies since last year. They further hiked their interest rates on 1^st and 2^nd February despite their inflation rates having peaked and started falling (see Tables 1 and 2 below).

• Fed - 25 bps to 4.50%-4.75% on 1^st Feb 2023. This is the eighth consecutive hike for total hike of 4.50% since March 2022.

• BOE - 50 bps to 4.00% on 2^nd Feb 2023. This is the ninth consecutive hike for total hike of 3.90% since December 2021.

• ECB - 50 bps to 3.25% (marginal lending rate) on 2^nd Feb 2023. This is the fifth consecutive hike for total hike of 3.00% since July 2022.

Policy rhetoric

Their repeated policy rhetoric on raising interest rates at present is “to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time” in the case of the Fed and “keeping them at levels that are sufficiently restrictive to ensure a timely return of inflation to its 2% medium-term target” in the case of the ECB.

While the ECB confirmed another rate hike of 50 bps in March, the Fed stated that ongoing rate hikes would be appropriate. The BoE notes that there is still some way to go in taming inflation. As such, all three central banks are to stay the course of hiking rates in 2023 as well until the disinflation reaches sustainable levels. The reason they cite is that the inflation is still wide spread at excessive levels as compared to their target of 2%.

However, nobody has any idea of the level of interest rates sufficiently or adequately restrictive to return inflation to 2% and how long it takes, other than the words " in the medium-term or over time."

They usually talk about anchoring inflation expectations around the target inflation. Policy statements carry a standards bunch of words on imaginations, views and hypotheses without underlying data to establish their meaning.

Policy irrelevance in the present context

• Irrelevance of recession and labour market slack expected

While central banks continue to raise interest rates at a historically high speed, they talk about getting inflation down with a soft landing, i.e., marginal reduction in growth and employment. Economists and market analysts around the world are busy with stories of expected recessions because of the conventional belief of the economic downturn in response to high interest rates and monetary tightening. However, money dealers who do not have any macroeconomic interest are busy with speculative trades for profit by using various dealing strategies designed to suit the prevailing rate hike cycle and subsequent rate cutting cycle.

However, unexpectedly, unemployment is falling to historic lows in developed countries while labour markets remain tight with rising wages due to labour demand higher than supply. As supply bottlenecks created by global Corona pandemic since early 2020 and Ukraine-Russian war since February 2022 continue to ease, supply side shows noticeable improvements despite monetary tightening. Therefore, price pressures have fallen noticeably without signs of recessions envisaged. As such, it is not the monetary tightening but the supply side improvement that has caused the commencement of disinflation path.

• Irrelevance of demand driven inflation

Monetary policy is a conceptual framework designed on old style of demand driven inflation concept developed in tribal economic era with cash dominance and closed economies. The model believes the national income identity and the change in the general price level as a result of imbalances between aggregate demand and aggregate supply in the economy. Therefore, the assumption used by old monetarists for inflation is the rise in demand funded by money over the supply given externally. Accordingly, monetary policy has been designed for targeting or controlling demand-pulled inflation where the major policy instrument at present is the central bank overnight interest rate.

However, present global inflationary pressures are a supply side phenomenon combined with cost-push prices and market expectations on global instabilities. The Fed Chairman at the last press conference responded to a query about present disinflation without weakening in the labour market that “it's a question no one really knows. I think it's because this is not like the other business cycles in so many ways.” This confirms that the old monetary policy concept is used to deal with inflation in business cycles familiar in advanced market economies and, therefore, it is not the case for the present global economy and rising inflationary pressures consequent to supply side bottlenecks.

• Irrelevance of Statistical Inflation Numbers

The inflation number used for the monetary policy decisions is the statistically computed percentage change of the Consumer Price Index (CPI). This is a statistical inflation that largely depends on the base or denominator (last year CPI). Therefore, present inflation peaking and thereby disinflation is a result of the base effect which does not show the extent of macroeconomic inflation and its impact on living standards. Data show peaks of inflation and CPI at different months while inflation falls as CPI rises. Statistical inflation can be computed on other term such as annual average or quarterly average whose results are different from annual inflation.

Central banks do not have a macroeconomic story connected with the monetary policy for changes in inflation numbers. Instead, they analyse categories of price changes such as food prices, energy prices, housing costs and services prices represented in the CPI basket to show the causes underlying changes in inflation while referring to interest sensitive demand sectors and wage sensitive demand sectors. This is a cost of living analysis used for fiscal measures and does not suit for monetary policy decisions which are expected to effect on prices through commodity and factor markets. That is why central banks themselves treat monetary policy as a blunt tool.

In the current context of improvement in global supply chains, disinflation will continue even if central banks cut interest rates. Further, interest rate is a real world economic activity that helps allocation of productive resources through changes in the cost of production and cost of living in modern credit-based monetary economies. There is no argument that high interest rates push up prices in markets and cause market imbalances until market participants adjust to new prices. In fact, arbitrary changes in interest rates by central banks would cause unnecessary noises to economies and price levels. 

Therefore, the so-called transmission story of central bank overnight interest rates with lagged effects on statistical inflation is a fiction as none has empirically proved it. If central banks are sure of the magical power of monetary policy on driving prices and cost of living, they must target CPI itself and be publicly accountable, rather than targeting meaningless percentages changes of the CPI and policy rhetoric not understood by the public. However, they are not willing. If central banks had magical powers in controlling inflation around their targets as they claim, present red hot inflationary pressures of four decades would not have occurred around the world having a central bank in each country.

Adverse impact on emerging market struggling economies

As almost all central banks follow the monetary policy model of the developed countries, all of them are now in the rate hiking cycles and will hike rates again in this month for an attempt to stop foreign capital outflow back to developed countries led by the US with lower business risks. High interest rates means that capital must be reallocated to riskier businesses to earn higher returns to pay higher interest rates on capital, which is a fact well known by international investors. 

While countries with strong export sectors and foreign currency reserves are able to survive in the competitive rate hiking cycle for some time, countries like Sri Lanka and Pakistan whose domestic economic activities are sinking in bankruptcy due to high interest rates and acute shortages of foreign reserves have no way for survival from high risks. However, they also will raise interest rates blindly by following their monetary god fathers. Central banks in developed countries have the luxury of raising interest rates because fiscal policies protect people who loose employment. However, developing countries do not have a fiscal safety net for the unemployed as governments also struggle in public finance.

The IMF and World Bank do not comment on such a rapid rate hiking cycle of reserve currency countries, its catastrophic effects on developing countries and possible instability in the global economic activities. Instead, they live on bailout packages and flawed desk-top projections on the global economy compiled by hired economists who never have hands-on experience in managing economies.

First, there is no place called a global economy as countries in the world are highly diverse and fragmented. Therefore, globally aggregate numbers are meaningless. Second, their projections and bureaucratic reports such as Global Economic Outlook, Global Financial Stability Report and Fiscal Monitor are not understood by even those who compile them.

However, without any attempt being made to discipline their wealthy members in economic fairness and justice to poor members like Sri Lanka, they persuade poor countries to tighten both monetary policy (raise interest rates) and fiscal policy (raise tax and cut spending) without any idea of its socio-economic consequences. They use their agents in respective countries to do the job by selling the rhetoric to political leaders who treat such policy recommendations like macroeconomic theology. 

As such, these countries have become generational beggars to the consortium of IMF, World Bank, their masters and investors. The western monetary policy serves as the effective conduit connected through reserve currencies and capital flows. The socio-economic catastrophe created by this is well known in countries hit by currency crises from time to time, including Sri Lanka at present managed by their agents. Sri Lanka after having 16 IMF bailouts with latest in 2016-19 and several rounds of World Bank financial packages along with the US monetary policy model and financial sector assessment programs has now been trapped in a currency crisis waiting for another IMF-World Bank-western investor bailout which is being dragged for one year.

The latest experience is the global economic disruption created by adamant, consecutive eight rate hikes by the Fed in 2017/18 from 0.75% to 2.50% which almost caused a global currency crisis by capital outflows and economic downturn. The President Donald Trump brutally criticized the Fed and looked for the possibility of even sacking the Fed Chair. Finally, the US economic disruption forced the Fed to reverse the cycle since the beginning of 2019. Later, the Fed Chair (present Chair) commented that the same mistake would not be committed again. 

The present hiking cycle is still not seen as the same mistake as economies recover from external supply bottlenecks and resulting reduction in unemployment, but its impact would be catastrophic to many developing countries. Such countries like Sri Lanka hit by foreign currency and debt crisis will not escape the bankruptcy in the present generation. 

Final Remarks

It is encouraging to note that Dr. K V Subramanian, IMF Executive Director for India, has criticized world monetary policies as damp squibs at a recent central bank public seminar as reported by Dailymirror 28 January 2023. His criticism has been centered around the flawed concept of money multiplier on which monetary policies are built, which has been proved to be ineffective. He, therefore, has stated that the monetary policy framework followed by central banks has failed to deliver the expected results in terms of creating economic growth and prosperity.

My thoughts above prove that inflation control claimed by central banks is also a flawed concept proved to have failed.

Therefore, countries like Sri Lanka sinking in economic bankruptcy caused by same monetary policies must invent a coordinated fiscal and monetary framework to develop respective countries on domestic resources base and skills that enable to attract foreign incomes without begging for foreign capital vulnerable to monetary policies of developed countries. 

Nobody can find fault with the resource base available in Sri Lanka being an old country in the global history. What is required is a new governance framework that respects and encourages a supply side focused policy framework in place of the old demand management approach that has already proved to have been failed causing catastrophe to the general public. This is possible only if we leave the global club of flawed and failed monetarism as soon as possible.

However, we should not be surprised if our central bank raises interest rates again in March or even before in view of statistical inflation standing around 50%, i.e., ten times the target, despite the deep contraction of the economy, as its economists do not have the backbone to think domestically and leave the Global Monetary Club or IMF macroeconomic management theology.

Table 01 - Interest Rate Hikes by Fed, BOE and ECB, bps, 2022-23
Fed	BOE	ECB
2022 March - 50	2021 Dec - 15	2022 July - 50
May - 75	2022 Feb - 25	Sep - 75
June - 75	March - 25	Nov - 75
July - 75	May - 25	Dec - 50
Sep - 75	June - 25	2023 Feb - 50
Nov - 75	Aug - 50	Now 3.25%
Dec - 50	Sep - 50
2023 Feb - 25	Nov - 75
Now 4.50%-4.75%	Dec - 50
	2023 Feb - 50
	Now 4.00%

(This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures.)

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 publish. 

The author holds BA Hons in Economics from University of Colombo, MA in Economics from University of Kansas, USA, and international training exposures in economic management and financial system regulation)