Central Banks move to flexible inflation

targeting: Wide public education is needed

Central Bank of Sri Lanka Senior Deputy Governor Dr. Nandalal Weerasinghe

Going for inflation targeting in full strength

Monday, 27 November 2017

Delivering the Henry Steel Olcott Memorial Oration

2017 in Colombo recently, the Central Banks Senior Deputy Governor Dr.
Nandalal Weerasinghe outlined the change of the game plan of conducting
monetary policy by the bank in the years to come (available at:
http://www.cbsl.gov.lk/pics_n_docs/02_prs/_docs/speeches/speech_20171120e.
pdf). That was to control inflation directly instead of controlling intermediate
factors that contribute to inflation.

This novel method known as inflation targeting or IT has been adopted by at

least 28 central banks, according to IMF, in the globe since late 1990s. The main
proponents have been the Bank of Canada, Bank of England, Reserve Bank of
Australia, Reserve Bank of New Zealand and Bank of Korea from the developed
world and Bank of Thailand and Reserve Bank of South Africa from among
emerging economies.

Attaining virtual price stability

Central banks throughout the world have been mandated by people to maintain a
stable general price level or in other words, an inflation-free world in their
respective countries. However, in practice, the goal being pursued is not the
attainment of a completely stable general price level or zero inflation rate. It is
simply the maintenance of a more or less stable general price level or a virtually
inflation free world.

What is meant by more or less stable prices is that prices could change but in
small paces, say, at a rate of about 2% annually. That increase in 2% is viewed as
necessary to reflect the improvement in quality of goods and services for which
consumers are prepared to pay more. Thus, when that 2% is removed, it is
practically an inflation free world.
Price stability will build confidence
If the change in the general price level from year to year is within this region,
people will trust their Central Bank, and hence the Government above it as well,
that together they would not disappoint them at the end. Such confidence would
create all the incentives for them to take a long-term view of the economy and
make appropriate choices on both consumption and investment.

But, on the other hand, if inflation is higher than what had been promised
initially, they would experience an erosion of the real value of all the financial
assets they hold cash, bank deposits, bonds, debentures and so on. To protect
them from the imminent losses, they would increase consumption, reduce
investment or convert their financial assets to unproductive real assets such as
land, real estate, gold or precious stones or go for a combination of all these three
options. They are called unproductive real assets because they are held not for
creating wealth but temporarily as a hedge against inflation.
Adverse impact of increased consumption

If consumption goes up, it would further fuel inflation and to the extent the
country is free to import, cause the current account of the balance of payments to
record a deficit. If the existing foreign reserves are used to fund this deficit, there
would be an erosion of the foreign reserve base. It would put pressure on the
exchange rate to depreciate. To avoid such an eventuality, the country would be
forced to borrow abroad, thereby increasing its external indebtedness and long-
term vulnerability. The reduction in investments in the current period will cause
the future growth to decelerate. Thus, the country is the loser on every count if
inflation is not tamed.
Higher inflation boosts inflation expectations

In the present monetary policy practices in which central banks are controlling
money and credit to maintain inflation at the desired levels, this is exactly what
has happened. At the beginning of the year, a Central Bank would promise its
people that it would keep the inflation in check and not allow it to go above a
certain maximum level. But, at the end of the year, the actual inflation would be
much higher than what had been promised initially. If it happens only in one year,
people will begin to believe that the higher inflation is temporary.
But if it happens year after year, people will expect inflation to prevail at high
levels continuously. Thus, mistrusting both the Central Bank and the Government,
they would begin to consume more, invest less and go after unproductive real
assets. Sri Lanka had been in this category since around 1980s. Hence, as
announced by Weerasinghe, the Central Bank, in a bid to break the vicious cycle,
has decided to change its monetary policy practice to inflation targeting. This is
indeed a way forward strategy. But its success depends on a number of ground
conditions being established in financial, economic and political arenas of the
country.

Government is to support inflation targeting

From the political side, the Governments Vision 2025 too has endorsed this
proposed monetary policy practice by the Central Bank. This writer in a previous
article in this series welcomed the move but warned that the Government should
free the Central Bank from the crutches of the Ministry of Finance if the inflation
targeting is to become a success (available at: http://www.ft.lk/w-a-wijewardena-
columns/Going-for-inflation-targeting---Yes--but-free-the-Central-Bank-from-
Ministry-of-Finance-first/885-642771).
The economic policy statement delivered by Prime Minister Ranil
Wickremesinghe in Parliament in October 2017 has put the Governments wish
more cogently as follows: However, the Government will provide the space to
the Central Bank to carry out its monetary policy independently to maintain price
stability on a sustainable basis. The Central Bank is moving towards a new
monetary policy framework targeting a flexible inflation. The aim of this
framework is to maintain a low inflation continuously while supporting the
economic activities. With this change of policy, our people will get the
opportunity to live comfortably with the security of stable prices.

What it means is that both the Government and the Central Bank will work
together to deliver price stability to the country. Thus, the Minister of Finance,
the agent of the Government to work with the Central Bank to accomplish this
mission, should extend all the support from the Ministry to make it a reality. This
is the challenge faced by the new Minister of Finance, Mangala Samaraweera. He
should refrain himself from criticising the work of the Central Bank in public as
was done by his predecessor both in and out of office. Such destructive criticisms
may be appealing to the uninitiated but will give wrong signals to citizens as well
as prospective investors. No right-minded investor will choose a country for
investment if its Minister of Finance is waging an open war with its central bank.
A well-researched oration

The oration delivered by Weerasinghe is well-researched and well-articulated. It

took the audience through the evolution of monetary policy in Sri Lanka and
finally made the case for moving into inflation targeting as the Banks new
monetary policy framework. Weerasinghe had documented that at every point in
Sri Lankas monetary policy history, the Central Bank had in fact changed its policy
framework when it had found the existing system not working or inadequate. In
this context, the Central Bank of Sri Lanka has been a flexible institution, ever
willing and ready to change its systems if they do not deliver the expected results.
Pitfalls of fixed exchange rates

Weerasinghe has discussed the evolution of monetary policy in Sri Lanka in the
light of different exchange rate regimes that had prevailed in the country. There is
a valid reason for him to do so. That is because the freedom which a Central Bank
has in conducting monetary policy is restrained by the type of exchange rate
policy the country has been following. For instance, if the country follows a fixed
exchange rate system, it is mandatory for the Central Bank to keep the rate fixed
by buying or selling foreign exchange in unlimited amounts.

If the going is good for the country like in the case of a commodity boom, there
will be a massive inflow of foreign exchange to the market. Since the supply is
much more than the demand for foreign exchange, under normal circumstances,
the local currency should appreciate. But under a fixed exchange rate system, that
cannot be permitted to happen. Hence, the Central Bank should buy the excess
foreign exchange that comes to the country by exchanging local currency. But, it
would increase the local money supply putting pressure for inflation to set in.
Thus, the Central Bank may be fixing the international exchange rate, but has to
allow the inflation rate, known as the domestic exchange rate, to set in the
economy.

So, a Central Bank is placed in a dilemma in such a situation. While preventing the
appreciation of the currency in the foreign markets, it has to prevent the
depreciation of the currency in the local market. The Central Bank of Sri Lanka
faced this situation in the rubber boom in early 1950s and it had to permit Sri
Lankan citizens to keep foreign exchange they earn in accounts abroad. It was
similar to Sri Lanka lending to foreigners just like what China is doing today.
Losing foreign reserves to fix the exchange rates

The opposite happens when there is a chronic shortage of foreign exchange. In

that situation, the exchange rate should depreciate but under fixed exchange rate
system, that too cannot be permitted to happen. Hence, the Central Bank has to
supply foreign exchange to the market to keep the rate fixed. But it loses foreign
exchange, runs down foreign reserves and to build reserves, has to borrow
abroad. If borrowing is not possible, the Government is forced to cut down the
demand for foreign exchange by introducing import and exchange controls.

When the ailment becomes acute, stricter import and exchange controls have to
be introduced. Since agriculture and industry loses raw materials, it brings down
economic growth as well. When there are shortages in the domestic market, price
controls have to be clamped. Since they breed black markets, goods have to be
distributed through a system of rationing. It not only generates inefficiency, but
also breeds corruption.

Since prices are controlled, consumer price indices hide the true inflation. The
result is the stagnant economy associated with suppressed inflation and
artificially maintained high exchange rates. Without foreign reserves, such a
system cannot survive for long.
Managed exchange rates are not better

Even after the country moved away from fixed exchange rates and adopted a
managed floating system in 1977, the problem remained the same. Under this
system, the Central Bank had a greater freedom to conduct monetary policy and
therefore the ailment was less acute. But the problems which the country had
undergone in the previous era were still present with erratic growth, one-way
journey to depreciation and open high inflation rates.

The banks attempt at controlling inflation by controlling money and credit did
not succeed since the Government, which ran high budget deficits year after year,
had borrowed in large amounts especially from the Central Bank. Such money
created by Treasury is known today as fiscal money as distinct from the fiat
money issued by a Central Bank. Fiscal money, together with fiat money, builds
pressure for inflation to rise in the economy. This disappointing experience has
forced the Central Bank to critically assess the validity and relevance of the
monetary policy framework the bank had been following.
The case for a flexible inflation targeting mechanism

The present situation faced by Sri Lanka is a paradox. On the one hand, as
Weerasinghe had presented, inflation has been at a single digit level for over 100
months. Yet, economic growth has been less than what its peers had been
attaining. The current account of the balance of payments had been eternally in
deficit and when the fuel prices were rising in the international markets, such
deficits had also been on the increase. Foreign reserves had been built up but not
out of earned foreign exchange; they have been built by borrowing abroad.

The exchange rate is eternally under pressure for depreciation. Thus, the country
has attained price stability, but not economic and price stability, mandated to
the Central Bank by Parliament. It has, therefore, become necessary for the
Central Bank to look for a more effective method of controlling inflation.

The solution it has found lies in the introduction of a flexible inflation targeting, as
against setting a strict target for the inflation rate. Under the flexible system, in
addition to having a low range for inflation, central banks will have a target for
real economic growth as well. This fits very well with the explicitly pronounced
objective of the present Central Bank of Sri Lanka, namely maintaining economic
and price stability.

Thus, as Weerasinghe has outlined, the Central Bank would endeavour to

maintain the total nominal output of the country, known as nominal GDP, under
its strict control. This, as Weerasinghe has explained at the beginning of his
oration, amounts to tackling inflation from the demand side. Any increases in the
general price level due to disturbances to the total supply, sometimes
erroneously called cost-push inflation, have to be tackled by the Government by
using weapons it possesses. For instance, if there is destruction of the agricultural
outputs due to any natural cause, the Government could still maintain the same
price level as before by allowing imports to come in or reducing the import duties.
The pre-budget reduction of the prices of a selected basket of essential food
items was done by the Government by using this method.
Need for effective communication with stakeholders

The Central Banks attempt at introducing a new flexible inflation targeting era is
a revolution by itself. Weerasinghe has said that within the Central Bank a lot of
model based research has been conducted to feed the necessary information for
the group handling inflation targeting to do its job. This is indeed praiseworthy
and a necessity. But at the same time, it is also necessary to educate all the
stakeholders of the necessity for and the fine details of inflation targeting. The
stakeholders involved are employees of the Bank, politicians on both sides,
media, trade unions and the general public. Without stakeholder cooperation, no
monetary policy package could succeed. Hence, conducting an effective public
education program is a must.

(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka,
can be reached at waw1949@gmail.com)
Posted by Thavam