Monetary Policy – For Monetary Board’s Intellectual Satisfaction or Recovery of the Public from the Economic Crisis?

During past few months, central banks around the world have raised policy interest rates by about 5-10 times the rates that prevailed at the end of 2021. This is the fastest monetary policy tightening phase recorded in the world to control inflationary pressures.

However, inflation has been rising non-stop while central banks tell various stories about rising inflation, tight financing conditions and their ability to control inflation back to targets (2% in developed countries from 6%-10% at present) in the medium-term to maintain the price stability in the medium to long-term.

Meantime, governments take various measures to ease the cost of living though fiscal measures such as energy subsidies and cost of living support to low income households. The good example is the UK’ growth targeted mini budget presented on 23^rd September with a package of historic tax cuts and a cap on household energy bills.

However, central bank talks are full of highly conceptual statements without any statistical proof and conflict with the previous statements.

Sri Lankan central bank is no exception as it also follows the western monetary policy model of overnight inter-bank interest rate targeting through the policy interest rates-based open market operations (OMO). In this model, central banks increase policy interest rates in a cycle and wait until inflation comes down through market forces in the medium-term not defined in calendar months.

Therefore, the purpose of this article is to question the credibility of the last monetary policy decision of the Central Bank of Sri Lanka based on the contents in the policy statement released by the Economic Research Department on 6^th October followed by a press conference chaired by the Governor.

My responses are given below each of the 15 statements selected from the policy statement one by one as indicated below.

1. Maintaining policy interest rates at current levels of 14.5% (SDFR) and 15.5% (SLFR)

This decision has no economic rationale in the present monetary policy model as inflation is rising and economy is contracting continuously as highlighted below.

• The last increase in policy rates was on 6^th July by 1% to the current levels after raising by 7% on 8^th April. After July, this is the 2^nd MB decision to keep the rates unchanged. However, inflation has steadily risen from 54.6% in June to 69.8% in September. Therefore, inflation has nearly tripled from March (i.e., from 18.7% in March). Further, inflation is now at 84.8% from the CPI reported in December 2019.

• The price impact of the increase in taxes is yest to come with a contraction of the economy by nearly 8%-9% by end of the year.

• The monetary financing (net) has accelerated by Rs. 517 bn or by 28% to Rs. 2,367 bn as on 6^th October as compared to Rs. 1,850 bn on 7^th April.  Nearly Rs. 481 bn has been printed through the purchase of Treasury bills outside weekly auctions. Further, no reduction can be expected in the near-term in the contracting economy although tax rates were increased.

• As stated by the Governor at the press conference, if inflation has been the result of the past monetary financing to the government, the present escalation of inflation should be a result of the escalation of monetary financing by him during the past 6 months.

• Exchange rate remains at elevated levels around Rs. 366 level without any sign of appreciation of the currency, given the rising BOP deficit (US$ 3,035 mn by end of August as compared to US$ 2,423 mn by end of August, 2021) although foreign debt service was defaulted on 12^th April.

• Therefore, there is no sign of inflation trending downwards soon. As such, the appropriate monetary policy decision in line with its present model should be to raise policy interest rates further.

2. The envisaged disinflation path in the near term supported by both domestic and global factors

This is a meaningless statement due to following reasons. 

• As highlighted in 1 above above, no domestic factors are available to predict a disinflation path or any inflation downward trend ahead. 

• As central banks are further raising interest rates while energy prices are expected to rise in the coming winter, no global factors of easing inflation can be expected.

3. The contractionary fiscal policies would complement the effects of tight monetary policy measures

This is a meaningless statement as commented below.

• The government has not announced a contractionary fiscal policy. According to the interim budget speech in August, the fiscal deficit has been revised to 9.8% of GDP from the original estimate of 8.8% or to Rs. 2,333 bn from the original Rs.1,628 bn.

• Although tax rates have been raised, an increase in tax revenue cannot be expected in a contracting economy. Therefore, the tax revenue in the interim budget has been revised down to Rs. 1,852 bn from the original estimate of Rs. 1,987 bn. As a result, domestic market borrowing including monetary financing will increase as the foreign debt is in default since 12^th April without any timeline for debt restructuring.

• Monetary policy, if it is independent, cannot expect fiscal policy support for its objectives. It must stay its own course. This is the global policy standard. 

4. Anchoring inflation expectations and bringing down headline inflation to the targeted level of 4-6 per cent over the medium term

This is a meaningless statement due to following points.

• Anchoring inflation is a monetary policy rhetoric coming in developed country monetary policy statements. However, no central bank has policy instruments to anchor inflation expectations around central bank targets because expectations of the public are psychological results whose market information is not available with central banks.

• The Central Bank does not publish any information on inflation expectations or source of surveys that collect such information.

• The Central Bank does not specify the medium-term in calendar time so that it is accountable in inflation control.

• Even if inflation falls to the target level, the prices and cost of living will continue to rise at lower rates and prevail high until there is negative inflation (price declines) and CPI falls to pre-2020 levels.  

• The Monetary Law Act (MLA) does not provide for inflation target-based monetary policy. The governing principles of the domestic monetary policy in the MLA are to secure the objectives of the Central Bank having regard to monetary needs of particular sectors of the economy as well as of the economy as a whole. The term inflation is not even motioned in the relevant provisions. Therefore, this statement as well as the monetary policy are in violation of the MLA.

5. The economy is expected to contract in the second half of 2022 as well, impacted by tighter monetary and fiscal conditions, along with the continuation of supply-side constraints and uncertainty surrounding the business environment amidst shortages of foreign exchange in the domestic foreign exchange market, among others. However, a recovery in economic activity is expected in 2023 with the envisaged improvements in the supply-side, along with the timely implementation of the required reforms

This is a statement without a focus due to following points.

• The contraction is primarily due to supply constraints caused by the collapse of the Central Bank foreign reserve, resulting control of imports and more than 80% increase in the exchange rate, global inflation, debt default and political/governance crisis.

• There is no information on tight fiscal policy.

• Tight monetary conditions refer to high interest rates only. Monetary liquidity remains highly lose as the Central Bank continues to print money without limit to lend to the government and banks. For example, the Central Bank’s holding of Treasury bills has risen to Rs. 2,367 bn as on 6^th October as compared to Rs. 1,850 bn on 7^th April whereas overnight lending by the Central Bank to banks has increased to a level above Rs. 700 bn as compared to well below Rs. 700 bn.

• Required timely reforms are not stated.

• Whether improvements in the supply-side and timely implementation of the required reforms to recover the economy in 2023 will take place or what are they are not stated.

• The recovery cannot be expected until cost of living is reduced to pre-crisis level. Further, a country hit by such a currency crisis cannot be expected to recover in one year when current economic difficulties confronted by Sri Lanka and country experiences are considered.

6. With relatively high deposit interest rates offered by licensed banks, a return of currency in circulation to the banking system is also observed.

This is meaningless and technically incorrect statement due to following points.

• Although the Central Bank has daily information on currency in circulation, statistics have not been given to prove the statement.

• According to the Central Bank web information, currency in circulation has risen by 2.3% to Rs. 1,124 bn as end of July 2022 from the level of Rs. 1,099 bn reported in March.

• Deposits are mostly money created by the banking system through lending and not by depositing currency in banks.

• Even if currency returns to banks from the hand of public, it is still in the money stock/supply or liquidity available for aggregate demand because it only changes the money from currency to deposits.

• In the event, the public and banks reduce currency holding relative to deposits, the currency ratio will decline and, as a result, the money/credit multiplier will rise causing monetary expansion. This will counter the present tight monetary policy.

7. In August 2022, outstanding credit extended to the private sector by commercial banks contracted for the third consecutive month in absolute terms, reflecting the impact of increased effective market lending interest rates, a moderation of economic activity, and measures to curtail non-urgent imports.

This is meaningless due to following reasons.

• Monthly contraction of the private sector credit will not lead to decelerate monetary expansion as the state sector credit continues to rise as the proportion of the state credit in the domestic credit is high at 53%.

• The Central Bank is not able to contract state credit as the cash-trapped government will continue to borrow by not responding to rising interest rates which has already risen above 32%.

• Monetary statistics are misleading of demand pressure as they are inflated by revaluation relating to steady 85% increase in exchange rate on foreign currency denominated credit and deposits. Since mid-May, there has been a slight appreciation of the currency due to new exchange rate guidance regulation with lower-level corridor and the resulting revaluation has caused the deceleration of credit and money.

• Private credit has been affected by the reluctance of banks to lend as banking risk have considerably increased in the current crisis. Therefore, banks have tended to invest more in Treasury bills at interest rates above 30% out of deposits mobilized at rates blow 20%, rather than risky lending to private sector with already rising non-performing loans.

8. Market interest rates are continuously adjusting upwards reflecting the tight liquidity conditions in the domestic money market and the further passthrough of significant monetary policy tightening measures introduced thus far by the Central Bank

This is baseless due to following reasons.

• Market interest rates are rising in response to policy rates hikes and sharp increase in yield rates of government securities.

• There is no tight liquidity as the Central Bank has increased money printing to avoid a liquidity crunch and a banking crisis.

• Due to high liquidity, the call money market has recently declined to zero level/non-activity as banks can borrow daily from the Central Bank through the SLF window.

9. Accordingly, the current declining trend in the year-on-year growth of credit to the private sector is expected to continue during the remainder of the year, while a similar trend is expected in the growth of broad money (M2b) supply as well.

This statement is misleading due to following reasons.

• Monetary statistics from March 2022 are not reliable due to valuation effect of the heavy currency depreciation on foreign currency denominated deposits and loans.

• Credit and monetary growth in real terms is already negative since January 2022 despite the valuation effects of the exchange rate. For example, negative real growth of M2b (year-on-year) based on December 2019 consumer price level has risen from 14.5% in May to 30.6% in August. Therefore, the quantity of demand out of the monetary expansion also should have fallen by now. As a result, demand-driven inflation also would have fallen significantly by now. However, inflation has been accelerating due to other factors such as supply side disruptions and shocks.

• Therefore, interest rate hikes also have contributed to severe contraction in the economy and bankruptcy of the state and private sector.

10. Meanwhile, the need for further monetary financing is expected to reduce gradually, supported by the envisaged fiscal consolidation measures and planned reforms of major state-owned business enterprises.

This is pointless due to following reasons.

• The present Governor assumed duties by bravely stating that he would professionally and independently reduce monetary financing and Central Bank Treasury bills holding. However, as stated above, monetary financing has risen to historical levels every day. The increase during his tenure so far is Rs. 517 bn or by 28% to Rs. 2,367 bn.

• Fiscal consolidation and reforms mentioned above are only expectations. Same were prevalent throughout the past too but not realized.

• It is not the standard practice to plan or implement the monetary policy on expectations of fiscal policies taken into monetary policy function.

11. Headline inflation is expected to follow a disinflation path in the period ahead. Subdued aggregate demand pressures resulting from tight monetary and fiscal conditions, expected improvements in domestic supply conditions, normalisation in global food and other commodity prices, and the timely passthrough of such reductions to domestic prices, along with the favourable statistical base effect, will be instrumental in bringing down inflation over the medium term.

This is an irresponsible statement as the Central Bank mentions all possible factors based on unestablished expectations. 

• According to the Central Bank, it is the monetary policy that tames the inflation to preserve the price stability by reducing the demand pressure to match the supply side. Therefore, it must specifically state how the monetary policy tightening will reduce inflation.

• Favourable statistical base effect as a reason to bring down the inflation shows that inflation number itself is flawed measure.

• At the press conference, the Governor stated that the inflation will start falling from October. However, he has predicted inflation peak at different months at different press interviews. For example, at the monetary policy press conference held on 18th August he stated that inflation would be peak at 65% in September. However, inflation rose to 69.8% in September. His earlier peak published in July monetary policy statement was 65%-85% in the fourth quarter 2022. The forecast published in the current press release is not acceptable as it states that the forecast is neither a promise nor a commitment. It is the general practice of all central banks to provide such inflation peaks not realizable. 

12. The merchandise trade deficit contracted significantly during the eight months ending August 2022, compared to the same period in 2021, driven by an increase in export earnings, while also reflecting the impact of policy measures taken to curtail non-essential imports.

This is only an ad-hoc improvement. However, the BOP deficit has continued to rise despite the default of debt service and, therefore, economy’s foreign currency crisis is not expected to ease. The BOP deficit at the end of August is US$ 3,035 mn, the largest compared to the deficit of US$ 2,423 mn in 2021 and US$ 722 mn in 2020.

13. The weighted average spot exchange rate remains unchanged since mid-September 2022 due to relatively low volume of transactions in the interbank spot market.

This is a meaningless statement due to the following reasons.

• The weighted average spot exchange rate has not been published in the statement.

• The exchange rate remains unchanged since banks comply with the fixed exchange rate guidance regulation issued by the Central Bank in mid-May.

• Relatively low volume inter-bank transactions as the reason for the exchange rate to remain unchanged is bizarre. However, the real reason is the above-mentioned guidance rate regulation with inactive foreign exchange market.

14. The Board was also of the view that the recently introduced tight fiscal policy measures would also help curtail any further build-up of demand pressures in the economy, complementing the effects of tight monetary policy already in place

As already stated above, monetary policy cannot function on favourable expectations of the fiscal policy. Further, tight fiscal policy measures stated above are not yet known.

15. The Board reiterates its commitment to restoring price stability and remains confident that the already implemented tight monetary policy measures would help rein in any inflationary pressures, while supporting the economy to reach its potential over the medium term.

This is a technically incorrect statement due to following reasons.

• As stated above, high interest rate monetary policy cannot reduce inflation because present inflation is largely due to supply side bottlenecks, foreign currency crisis and global inflation.

• High interest rates have fueled the supply bottlenecks and economic contraction through increased cost of production and credit risk. The Governor has stated at all media meetings and presentations that there is not option to control inflation other than significant contraction of the economy to cut down the demand. Therefore, the aim of the present monetary policy is to contract the economy further.

• As the real monetary growth is already negative 30.6%, the contraction caused by the monetary tightening would be huge by now.

• Therefore, statement on supporting the economy to reach its full potential over the medium term is incorrect. Further, full potential is only a word without any measurement.

Final Remarks

Above comments confirm that the present model of the monetary policy has immensely contributed to the historic contraction of the economy at present. However, the MLA does not provide for the monetary policy to be implemented for such a conscious contraction or for inflation target.

The President in his statement made to the Parliament on 6th October in the capacity of the Minister of Finance stated that high interest rates prevailing and resulting economic contraction through the adverse impact on the private sector were not acceptable for the economic recovery. In the Parliamentary debate, the Opposition Leader also commented that the economic contraction was not acceptable.

Therefore, the opinion of the Minister of Finance and government on the implementation of the Monetary Policy to the greatest advantage of the people of Sri Lanka at this stage is different from that of the Monetary Board.

If so, two options are available. Either the Monetary Board should step down as professional and independent members or the Minister of Finance should direct the Monetary Board under section 116(2) of the MLA to adopt a monetary policy as directed by the Minister. It is simple macroeconomics that a recovery from an economic crisis or a severe contraction or a recession is possible only by implementation of a policy relaxation or monetary and fiscal expansion. For example, the UK government has embarked on a considerable fiscal expansion aimed at growth enhancement to reduce rising inflationary pressures without causing a recession.

Otherwise, the Minister of Finance also would be responsible for the economic contraction of the economy created by high interest rates based monetary policy continued by the Monetary Board. This would be an early warning, given current concerns over economic crimes due to policy problems and fundamental rights cases being filed in the Supreme Court.

 (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 published)