Politics of Monetary Policy - 1% rate cut on the table?

 

Article's Background

This article predicts that the Monetary Policy Board at the next meeting due on 24 July at 7.00 a.m. will cut the policy interest rates at least by 100 basis points in view of the present macroeconomic outlook and political stability pending the Presidential Election in October.

Policy rate decision by central banks cross the globe is a highly arbitrary bureaucratic exercise. It is based on qualitative judgement on the outlook of the consumer inflation and possible deviations from the inflation targets of central banks. However, central banks can provide diverse macroeconomic stories to support what ever the policy decision as they wish as nothing is experimental or empirical or past perormance is legally assessed.

The Federal Reserve Chairman Jerome Powell stated at the latest testimony before the Senate Banking Committee held on 09 July 2024 that the Fed would not need to wait for inflation to reach exactly at the target (2%) to commence the rate cutting cycle. Instead, what is necessary is the confidence that inflation is sustainably reduced towards the target.

List of key supporting factors for the predicted rate cut 

• The CB Governor's macroeconomic perception disclosed at the beginning of the inflation control in April 2022 was that it would be easier to control inflation first by contracting the economy and then rebuild the economy through relaxed monetary policy. Accordingly, policy rates were raised precipitously to 15.6%-16.5% by April 2023 from the level of 6.5%-7.5% in March 2022.

• Accordingly, inflation has now declined to be around zero from its peak of 70% in September 2023 (as compared with 19% in March 2022) with a substantial negative economic growth of 7.3% in 2022 and 2.3% in 2023. Inflation has remained close to zero for the past four months. Therefore, the monetary policy now needs a substantial and long-term policy rate cut to boost the growth of the economy in a sustainable manner.

• The banking sector now sits on a substantial liquidity surplus pending to be absorbed by the economy through credit expansion requiring lower interest rates, given the wide-spread economic contraction in the past two years. 
• According to policymakers, the economy has now been stabilized from 2022-2023 crisis through the IMF progamme with debt restructuring, rebuild of the foreign reserve to US$ 5.6 bn., significant appreciation of the currency to closer to Rs. 300 at present from Rs. 380 in May 2022 and fiscal space under control with revenue expansion while expenditure and debt rationalized. 
• The present excess liquidity is a direct result of the BOP surplus, central bank's continued liquidity injection through revere repo auctions and weaker credit conditions in the economy. 
• Therefore, a sizable policy rate cut is necessary to sustain the economic stabilization pending the Presidential election.

• Operating target of the monetary policy, i.e., the call money rate, has reached closer to lower bound of the policy rates corridor for several months now requiring the space for further downward movement consequent to the huge excess liquidity conditions.

• Treasury bill yields have fallen to the policy rates corridor due to favourable liquidity and improved market confidence arising from debt restructuring and fiscal improvements. Therefore, the fiscal front now desperately needs a new breath to reduce the cost of funds, given its space under control.

• The BOP surplus and currency appreciation will help imports to boost the growth and employment opportunities if interest rates are reduced to accelerate credit expansion as inflation is seen now controlled sustainably below the target of 5% under the newly independent monetary policy authorized by the new Central Bank Act. Therefore, public confidence on the ability of the central bank to control inflation remains strong.

• The rate cutting cycle which commenced in May 2023 at the time inflation was as high as 25% has been kept unchanged for the past four months, despite the drastic fall of inflation below the target of 5% and the need to move towards pre-rate hike cycle in order to support the sustainability of the economic recovery and growth.

• Central banks of all advanced economies are now ready to commence the rate cutting cycle shortly as inflation has now reached closer 2% target while the European Central Bank has already commenced rate cuts in last June in view of soft landing conditions against the speculated hard landing in the US and Europe.

The graphical presentation supporting the favourable market outlook for the predicted rate cut is given below.

Conclusion

In view of key macroeconomic factors listed above, the Monetary Policy Board should cut policy interest rates at least by 100 basis points.

However, the Policy Board can fabricate a different policy story as follows to keep policy rates unchanged if it wishes to avoid supporting the government in the pending Presidential  Election.

• Policy rates have been reduced by 7% in the current rate cutting cycle so far in four instances.

• Therefore, markets have further space to reduce interest rates in line with policy rates and prevailing excess liquidity.

• Full effects of stabilization policy package are expected to boost the supply side in the medium-term. Therefore, prevailing excess liquidity and stabilization have the potential of causing inflationary pressures in the near-term, given possible inflationary effects of near-term rate cuts expected in developed market economies. This may weaken inflation expectations that are well anchored at present and is likely to pose risks to the monetary policy in the medium-tern.

• Therefore, further confidence is necessary that demand pressures in the economy are contained until the supply side comes back strongly in the medium-term.

However, whether policy rates are cut or kept unchanged depending on whatever the policy rhetoric fabricated at the next monetary policy meeting, the economy will not experience in any favourable progress in the near-term or medium-term, given the structural bottlenecks on mobilization of resources and investments. 

Therefore, the economy will continue to exhibit short-term stabilization achieved on foreign debt newly arranged by the government in pursuit of interim political benefits. Therefore, present policy story is only a fictitious tinker on same old problem.

The present model of policy rates based monetary policy has no role in bankrupt economies as it has no instruments to fix supply side bottlenecks directly or indirectly. 

Therefore, its only purpose is to print several billions of money daily through various devices to finance liquidity mismatches of bank dealers on the ground of financial stability.

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. All are personal views of the author based on his research in the subject of Economics which have no intension to personally or maliciously discredit characters of any individuals.)

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 12 Economics and Banking Books and a large number of articles published.