Monetary misbalances. Another rate hiking cycle is ahead for a new round of misbalances? Saving the world economy from Iranian war or sinking it?

 

The monetary policy rhetoric of central banks around the world is that they balance interest rates, exchange rates and liquidity to ensure the price stability within a target of inflation. Its underlying story is that the price stability provides the certainty and impetus beneficial to growth, employment and living standards.

However, the general experience is that none of such balances is enjoyed by the general public whereas economic crises hit from time to time due to grave misbalances.

Therefore, this short article is to show how misbalances prevail among interest rate, exchange rate, liquidity and inflation, taking Sri Lankan economy as the example.

However, the article does not highlight any specific reasons and events underlying such misbalances.

The target audience of the article is the readers who are familiar with the central bank monetary operations and policy communications.

Key indicators of monetary misbalancing

Inconsistencies of policy outcomes and policy conduits

• Major policy outcomes expected from monetary balancing are the market liquidity (cash reserves of the banking system) and exchange rate. However, both variables show wide dispersions.

• Policy interest rates and net foreign exchange purchases are the major policy conduits used to balance between liquidity, inflation and exchange rate. However, wide variations of these conduits show the inconsistency among the three policy outcomes (see the chart below).

Inconsistency of monetary operations, market liquidity and exchange rate

• Policy rates along with monetary operations (such as standing facilities, repo operations and reverse repo operations) are inconsistent with the varying levels of the exchange rate and market liquidity (see the chart below). If the monetary balancing is proper, the market liquidity cannot experience such degrees of volatility and dispersions.

• Movements of the use of standing facilities are inconsistent with policy rates (see the chart below).

Inconsistency of policy rates corridor with the call money rate

• Inter-bank overnight call money rate being the primary conduit of the policy rates-based monetary policy shows irregular behavious despite the policy rates corridor and connected open market operations used to balance between the domestic currency and foreign currency liquidity levels (see the chart below).

Questionable conduct of monetary operations

• Instances of questionable open market operations have been reported from time to time attributing to such inconsistencies.
• For example, inter-bank interest rates were artificially pushed down during Sep - Dec 2024 with an excessive use of reverse repo auctions at interest rates significantly lower than the overnight standing lending facility at a loss to public funds (see the chart below).

• Further, from the middle of February 2026, an excessive level of repo auctions has commenced to mop up the excess liquidity at rates above the overnight standing deposit facility, again a loss to public funds. However, the market response so far has been to push down the inter-bank interest rates although the reverse should be expected (see the chart below). Therefore, the intension of repo auctions is not clear, other than financial losses.

Excessive monetarization based on the dollar

•  While the level of reserve money has been largely driven by the dollar reserve of the central bank, money supply has been excessively monetarized outside the dollar although the economy is largely driven by the dollar flows.

• This discrepancy is shown by the market exchange rate, exchange rate of reserve money (units of reserve money per dollar of the reserve) and exchange rate of money supply (units of money supply per dollar of the reserve). While the money supply exchange rate has drastically over-shooted during the last two decades, other two exchange rates have been largely balanced by the dollar reserve (see the chart below). This reveals a significant systemic risk of the monetary/financial system exposed to the dollar flows underlying economic dollarization.

Public debt mostly victimized by monetary misbalances

• Government securities market is the mostly victimized by monetary misbalances as yield rates were driven to implement the monetary policy (see the char below).

• Despite significantly high level of the market liquidity and record surpluses in Treasury bank balances (reported around Rs. 1 trillion), yield rates have tended to remain high or rise during the past three months even though auctions are now carried out by the independent Debt Management Office. Instead, a strategy beneficial to the fiscal management should be followed to reduce yield rates independently on the use of surplus Treasury funds (see the chart below).

• In addition to interest cost on government debt linked to monetary policy priorities, funding the dollar reserve and under-valued exchange rate by the govt foreign borrowing has been the biggest victimization as already reported by the default of debt in April 2022. The severity of this debt monetarization and misbalancing is shown by the debt exchange rate (the ratio of govt foreign debt to foreign reserve, i.e., govt foreign debt per the dollar of foreign reserve) around Rs. 1,700 for recent months (see the chart below). 

Concluding remarks

• Given the historical experience in monetary misbalancing highlighted above, the general public can never expect realistic and predictable levels of inflation, exchange rate, interest rates and liquidity to support the enhancement of real economy and living standards.

• The deep root of such monetary misbalances is the arbitrary conduct of monetary operations on a day-to-day basis driven by various monetary ideologies and contemporary shocks without a long-term focus for the desirable direction of the real economy for upliftment of living standards largely dependent on fiscal operations and underlying creation of state currency with its multiplier effects on the private sector.

• Many central banks making losses on money printing by paying interest on excess liquidity and fiscal deficits rising on interest payment on debt are significant losses to state currencies due to such monetary misbalances.

• In this background, the biggest risk is the rate hikes expected by central banks around the world as part of text book exercise to respond to the upcoming global inflationary waive caused by disruptions of global supply chains on the current war of the US and Israel with Iran (two weeks so far). This inflation is created by political leaders and cannot be resolved by central bank monetary policies.

• Therefore, the prospective rate hiking cycle may continue for a long-time depending on the duration of the war and its damage to global trade inclusive of energy and finance and may cause another cycle of significant monetary misbalances that are likely to cause heavy stagflation conditions around the world and another round of default of debt both domestic and foreign in the present new liberal model of economic management pursued around the world.

• Therefore, the biggest error made by lawmakers in country governance is the misbelief that central banks have tools to know the market prices and corresponding liquidity levels of state currencies that are appropriate for macroeconomic stability and living standards. Untill this error is rectified, monetary misbalances and resulting economic crises from time to time will be part and parcel of macroeconomic governance and living standards.

(This article is released in the interest of participating in the professional dialogue to find solutions to present economic crisis confronted by the general public. All contents in the article are based on the author's research and views on the subject which have no intension to personally discredit characters or ideologies of any individuals.)

P Samarasiri

(BA Hons Economics, University of Colombo, MA Economics, University of Kansas)

Former Deputy Governor, First Central Bank of Sri Lanka

(35 years of experience in staff class in the Central Bank, inclusive of Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 13 Economics and Banking Books and a large number of articles published.)