Fighting cost push inflation with tight monetary policy

The debate over expansionary fiscal policy took a new turn with Finance Minister Sarath Amunugama making apparently contradictory statements in the budget, when defending himself against charges of igniting galloping inflation by printing money. “The Honourable Finance Minister’s statement is what I call an oxymoron,” says Dr. Harsha de Silva, a leading critic of the money printing inclinations of the government.

Successive
populist governments of Sri Lanka have printed money in a mis-guided policy
to buy votes, with little public criticism, until now.

“On the one hand he says it is not a monetary phenomenon, and on the other hand he says the inflation rate came down because the monetary policy was tightened. So where is the coherence in that statement?”

Economists have pointed out that printing money to finance the budget deficit, and not the rising cost of oil, was the main reason for the rising inflation since the UPFA government came to office.

The Finance Minister’s paradoxical statements were made twice during the budget speech.

“Mr Speaker, cost-of-living is no doubt a major concern,” Finance Minister Sarath Amunugama said in parliament.

“We were mindful that inflation reached 16.00 percent on a year-on-year basis in January this year. We have reduced this to near 10.00 percent through monetary policy actions and various other measures. Nevertheless inflation is not purely a monetary problem as some ‘Pundits’ in our country think.”

He was responding to economists and the IMF who blamed expansionary fiscal policy and loose monetary policy in 2004, for the galloping inflation seen in the country since the Minister took office.

“We were
mindful that inflation reached 16.00 percent on a year-on-year basis in
January this year. We have reduced this to near 10.00 percent through
monetary policy actions and various other measures. Nevertheless inflation
is not purely a monetary problem as some ‘Pundits’ in our country think.” –
Sarath Amunugama

Wretched Subsidies

In 2004, the government used more than Rs. 60 billion in Central Bank credit (or three percent of GDP), to finance mainly subsidies, driving up inflation and creating a balance of payments crisis in the process.

Most of the subsidies went to fix petroleum prices, electricity – most of which is also thermally generated and imported commodities like fertilizer and wheat.

Though petroleum prices largely stayed put, prices of almost all other goods rose due to demand pressure.

Import prices also rose, as the ‘printed’ money put pressure on the balance of payments and drove the rupee down.

This in turn pushed the import prices of oil in rupee terms even higher, resulting in a need for an even larger subsidy to fix petroleum product prices, leading to a vicious spiral of galloping inflation which could have been avoided if petroleum prices were raised in the first place.

Flaming Fires

Inflation started to moderate after the government started adjusting petroleum prices. The Finance Minister is now saying that fuel prices would be market priced in 2006 and subsidies limited to Rs. 3 billion, down from about Rs. 20 billion.

Central Bank also stopped printing money after the first quarter of 2005, (in the wake of tsunami aid flows and higher government revenues) and has now sold down a part of its Treasury bill portfolio.

Fixing imported commodity prices or ‘removing the plug’ was a cornerstone of the Marxist Janatha Vimukthi Peramuna backed ‘Rata Perata’ economic strategy, which was implemented since April 2004, when the Minister took office.

Until that time inflation was in the low single digits.

“There
were cost-push issues and demand-pull issues,” says Dr. Harsha de Silva.
“And only because the printing of money came down after the so called
‘pundits’ talked about it, that inflation came down.”

Rising inflation soon overtook inflation, resulting in negative real interest rates, as the Central Bank initially stayed in the sideline without tightening policy. The negative rate structure is only getting partially corrected now.

“Having revived economic growth and absorbed the high price of fuel, the Government was confronted with inflationary pressures stemming largely from cost-push considerations,” the Minister said.

“This necessitated a tightening of monetary policy in order to encourage savings and rebalance demand pressures in the economy. The Central Bank raised its policy rate on several occasions. Consequently, the one-year Treasury bill rate has increased to 9.82 percent from 7.50 percent one year ago. Average weighted deposit rate has increased to 7.50 percent from 6.00 percent and credit growth in the public sector declined from 16 percent in 2004 to 14.00 percent in 2005. These initiatives have reduced year-on year inflation from 16.00 percent in January this year to 10 percent in October.”

If the government ‘absorbed’ the high price of fuel, the question of how oil prices got translated into inflation index during the price-fixing period was not explained by the minister.

Though there were some cost push factors as well (such as drought induced food prices), Dr. de Silva points out that the Finance Minister’s own admission that inflation came down after monetary policy was tightened, following public criticism, shows that inflation was largely a monetary phenomenon.

“There were cost-push issues and demand-pull issues,” says Dr. de Silva. “And only because the printing of money came down after the so called ‘pundits’ talked about it, that inflation came down.”

Successive populist governments of Sri Lanka have printed money in a mis-guided policy to buy votes, with little public criticism, until now.

The macro-economic destabilisation that follows deficit spending and money printing such as balance of payments problems and galloping inflation, has been blamed by economists for the rising poverty levels in Sri Lanka.

-Money Report Newsdesk: asantha@vanguardlk.com