Why the CB Governor will fail to deliver on his promises?

The objective of this short article is to present key reasons why the CB Governor will miserably fail in stabilizing the economy and getting the inflation down to a single digit by the end of this year as he promises.

Background of inflation control by the CB/Central Banks

• The CB like many other central banks believe that inflation inflation is a monetary phenomenon as a result of excess money stock causing excess demand for goods and services beyond the supply.

• Therefore, the strait forward answer that central banks have is to keep the monetary policy tightened in order to decelerate the monetary growth which will then decelerate the demand. They believe that this will drive inflation towards the target used for the conduct of the monetary policy. The inflation target in Sri Lanka is 4%-6% YoY as compared to 2% in developed countries.

• The present monetary policy is based on targeting the inter-bank overnight interest rates through central bank policy interest rates. Policy interest rates are the interest rates used by central banks for their overnight deposit and lending operations with banks and other permitted securities dealers. The CB's policy rates at present are the are standing deposit facility rate (SDFR) and the standing lending facility rate (SLFR) applied for overnight deposit and lending operations with commercial banks and primary dealers in government securities. 

• As central banks are prepared to lend and take deposits at these rates without any limits possible due to their money printing power, inter-bank overnight interest rates will remain within the policy interest rates corridor. Therefore, policy interest rates are a form of price controls in the overnight money market supported by money printing.

• Therefore, the key monetary policy decision taken by central banks from time to time is the determination of policy interest rates, i.e., hike or cut or hold at current level. In the case of hike or cut, by how much is the unjustified decision.

• Accordingly, in times of inflation rising continuously above the target, central banks keep hiking policy rates gradually until inflation is firmly back on the path to the target. At present, almost all central banks (except central banks in China and Japan) are on this game from the beginning of last year.

The CB's rate hikes in the current cycle

The CB commenced hiking policy rates in mid-August 2021 well before inflation started rising above the target. Accordingly, present policy rates corridor is 14.5%-15.5% elevated from 4.5%-5.5% in mid-August 2021 after five rate hikes with a total of 10% so far whereas the behaviour of inflation is not justified with policy rates (see the table and two charts below).

The present CB Governor accelerated the rate hikes by a record 8% expecting to be a world hero of inflation control in a crisis-hit economy. As a result, all interest rates rose to sugar high levels followed by the rapid rise of government securities yield rates to 30%-33% (see the chart below), despite the significant magnitude of money printing used to suppress the yield rates.

Even a layman will understand the catastrophe that the economy will suffer at such high levels of interest rates at the time it is hit by a historic economic crisis.

How rate hikes are expected to bring down inflation

Rate hikes are expected to slower the demand for goods and services and thereby reduce inflation through five major channels.

• First, interest rates throughout the economy will rise fairly quickly. Inter-bank interest rates and government securities yields will rise immediately and other interest rates will follow suit shortly.

• Second, as the cost of borrowing and capital is now higher, consumption and investment financed by credit will decline because modern monetary economies run on credit. This is the first round of deceleration in demand. This will effect primarily through the private sector as the government spending generally does not respond to changes in interest rates.

• Third, the second round of deceleration in demand comes through the contraction of production activities and employment. The reduction in private consumption and investments will contract production activities which will raise unemployment of factors. As a result, factor incomes, i.e., wages, rent, interest and profit, will decline. The decline in factor income leads to deceleration in demand. This happens primarily in the informal sector of the economy.

• Fourth, hike in interest rates will reduce the value of financial assets and wealth which is a factor contributing to consumption and investment of the private sector. Therefore, the depressed value of wealth also will reduce the demand, primarily through reduced credit on lower value of wealth/assets under collateral and reduced capital gains. This is also another source of deceleration in demand.

• Fifth, higher interest rates are expected to attract foreign capital in economies with open capital account if interest rates rise faster than those in countries competing for foreign capital. The new inflow of foreign capital will appreciate the local currency. The currency appreciation will raise the foreign currency price of exports and reduce the local price of imports. As a result, net exports (exports less imports) is expected to decline (depending on export and import elasticities), causing a decline in the demand. This is another source of deceleration in demand. In addition, the reduction in local currency cost and prices of imports also will directly reduce domestic prices and inflation.

Accordingly, the deceleration or reduction in the demand for goods and services will bring the demand to a greater balance with the supply, given externally. As a result, the narrower gap between the demand and supply will reduce the general price level and inflation. This is known as the transmission of the monetary policy.

This is what the monetary theory predicts as to how inflation will come down in response to policy interest rates hikes.

However, macroeconomic outcomes in reality are different from the theory. Further, side effects in the event interest rates rise stubbornly high could be catastrophic depending on their impact on the public trust in banking and finance. For example, unduly high interest rates can even cause banking and financial crises through various sources.

Can Sri Lanka expect above channels of monetary policy transmission?

Those channels cannot be expected because current inflationary pressures in Sri Lanka are not demand-driven. High inflation is a result of depressed supply side and cost-push amid the global corona pandemic, collapse of the import sector due to the CB's failure to maintain a foreign currency reserve for BOP purposes, excessive devaluation of the rupee by the CB (i.e., nearly 85% rise in the exchange rate), default of foreign debt, significant rise in globally energy prices and grave political and economic instability.

Therefore, policy interest rate even at 100% cannot resolve the supply side and cost push factor behind high inflationary pressures.

• First, high interest rates in fact will aggravate them through the increased cost of production and contraction of the economy via first three channels.

• Second, asset channel is very poor in Sri Lanka as compared to advanced market economies due to primitive capital market.

• Third, exchange rate channel is not available as the country is in default of foreign debt and exchange rate is administratively fixed at the over-value. Therefore, neither capital inflow nor currency appreciation can be expected even if interest rates are at 100%.

• Fourth, policy interest rates corridor is no more relevant for the policy transmission as the CB has imposed limits or rationing on its overnight standing deposit and lending operations with effect from 16 January 2023. As a result, money market volatility and manipulations seen at present have potentials of even hitting systemic risks in the current context.

• Fifth, the CB Governor has been running after the IMF for a loan of US$ 2.9 bn and debt restructuring for nearly one year so far. If he can stabilize the economy (greater balance between the demand and supply) and bring down inflation to a single digit by the end of this year through policy interest rates, the rationale for going after the IMF and debt restructuring, which are fiscal instruments, is questionable.

Fundamental problems in the monetary policy model

The present monetary policy model is implemented on unestablished concepts and bureaucratic discretion and, therefore, lacks the public accountability.

• The extent and duration of the policy transmission are not known and not empirically tested. Therefore, brave talks on transmission time of 12-18 months from each interest rate decision are just bluffs.

• The extent and frequency of changes in policy rates effected to hit the inflation target have no basis. Therefore, like in other central banks, the CB changes interest rates in different magnitudes at different intervals while sitting down and looking at inflation data.

• Rate decisions are taken by looking at the inflation rate estimated as the annual percentage change of the Consumer Price Index (CPI). This is only a statistical inflation rate driven by the base effect. Therefore, inflation tends to ease after some points even when the CPI and cost of living continue to rise or remain at elevated levels. The central banks boast on the prudence of monetary policy actions as soon as the disinflation begins due to the base effect, despite elevated price pressures broad-based across all sectors or markets of the economy.

• Interest rate is a key activity driver in modern monetary economies. It is a risk-based driver of distribution of productive resources and income. Therefore, policy interest rates and statistical inflation are unrelated variables to base the inflation targeting monetary policy. 

• Prices of goods and services and thereby inflation are a result of the interactions between commodity markets and factor markets. The inflation as defined in the monetary policy and economics is the change in the general price level due to imbalances between the demand for and supply of goods and services. Therefore, the use of CPI inflation and inflation analysis presented from price changes in the CPI basket is a flawed practice followed in monetary policy decisions.

• In modern open economies with electronic money and information technology, demand side and supply sides are inter-connected real time and, therefore, demand cannot be separated for the control of inflation as conceptualized in the monetary policy. In fact, supply chains inclusive of marketing drive the demand where both supply side and demand side are real time responsive to interest rates. In fact, it is the contraction of the supply side that has to reduce the demand in the second round in response to high interest rates. Therefore, the assumption of externally given supply side used in the monetary policy for the control of demand side through credit independently from the supply side is highly irrelevant and outdated.

• Although central banks state that interest rates/monetary policies get transmitted through interest rate sensitive demand sectors, they do not have any idea of what those sectors or impacts are. Instead, they analyze changes in the prices captured in the CPI to find out how inflation has changed. This is a highly unacceptable, micro analysis for a macroeconomic policy such as monetary policy.

• The CB's claim that high interest rates are required to control imports through costly credit due to foreign reserve problem is baseless. Import control is a fiscal measure. The use of policy interest rates for such cross purposes violates the present monetary policy model whereas the CB has direct measures to control imports.

Concluding Remarks

Several public concerns can be raised as below on present monetary policies of central banks.

• The present model of central banks as independent monetary authorities is outdated as their operations reflect extreme communism as well as extreme capitalism. Central banks are highly communist organizations as monetary side of the economy is centrally planned by few central bank bureaucrats. They are highly capitalists as they expect the market mechanism to drive prices, redistribution of resources and growth in response to centrally planned interest rates and money printing. Therefore, such dubious organizations run by few individuals pose a threat to modern democracy and economic freedom.

• The present model of policy interest rates-based monetary policy is highly irrelevant for economies confronted with currency and debt crises as the market mechanism is not available to transmit the monetary policy across the demand side of the economy as expected in monetary textbooks. Therefore, Sri Lanka cannot expect any stabilization through the present monetary policy.

• Devastating impacts of policy mistakes on generations and unaccountability despite continuing policy mistakes cannot be tolerated. The present interest rate policy of the CB has pushed the crisis-hit economy to bankruptcy, but political leaders who do not understand such facts treat the CB Governor as the divine landed to save the country from the economic crisis.

• Inability to assess the policy performance and effectiveness in modern market economies is a serious flaw. Therefore, underlying monetary concepts are practiced in line with closed, tribal economies with primitive currency .

• Inconsistency of policy statements, rhetoric, media interviews and forecasts which are made based on policy complacency results in the loss of policy credibility.

• The policy is expected to stabilize the economy, i.e., getting the demand to a greater balance with the supply, in old macroeconomic management models and, therefore, the policy is highly irrelevant for modern economies. When this is questioned, central banks state that only the interest rate instrument is available for them to stabilize the economy. If so, central banks fall far below the expectations built in relevant public mandates.

Therefore, it is high time for professionals and political leaders to debate on the relevance and usefulness of the present monetary policy models to the general public and to effect a model refix, accordingly, rather than calling for full independence offered to central banks for the control of the monetary side of the general public as central bank bureaucrats wish.

Otherwise, it will not take a long time for the state central banks to be extinct and for governments to loose the control over the economy. It is in this context that a new school of modern monetary theory has emerged to advise the policymakers because central bank officials are neither rocket scientists nor divine creatures.

(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)