Sri Lanka’s inflation debate: should the CB continue with ‘no policy action’?

Mar 19, 2010 (LBO) – Sources from the Central Bank indicate that the Monetary Board, in its deliberation for the monetary policy action in the month ahead, has decided to keep the ˜policy rates untouched’ for another month.

But, when the inflationary pressures are mounting and the aggregate demand is accelerating, the disregard of the powerful monetary policy instrument in the style of interest rate changes does not appear to be a sound policy action.

Monetary Policy following Election Cycles should be avoided

When central banks are not fully independent and subject to control, directly or indirectly, by governments, the world – wide experience has been that monetary policy actions have broadly corresponded to the election cycles of the countries concerned.

According to Alex Cukierman, an authority on central banking who wrote the book, Central Bank Strategy, Credibility and Independence, even the Federal Reserve Bank in the United States has not been free from this allegation.

In terms of this observed central bank behaviour, central bank actions are loosened during the times of elections to facilitate the party in power to get elected for a second term. Accordingly, interest rates are cut, credit is more liberally supplied, government’s excessive expenditure is funded basically through central bank financing and exchange rates are deliberately kept at levels for local currencies to have higher values against foreign currencies.

Sri Lanka has had two elections in the past eighteen month period and there will be another election in a month’s time. Hence, it is quite natural for the central bank authorities not to embarrass the government in power by tightening the monetary policy action, though the prevailing situation in the country may require the central bank to do so.

Elections are Undeclared Stimulus Packages

Elections are always huge money spinners, because candidates raise campaign money in large volumes to reach voters effectively within a short period of time. A very large segment of money so raised is simply money which has remained in sterile and hoarded form and which is now being brought back to recirculation.

Hence, election expenses are similar to economic stimulus packages implemented by governments to encourage consumption and thereby raise the total aggregate demand as a strategy to lift an ailing economy out of recession.

However, whether this strategy will be successful in raising the total output will depend on a single factor. That is, whether this economy’s problem has been due to a lack of demand for the output it produces and therefore, there is a pervading accumulation of unsold stocks of commodities and unutilised capacity in business firms.

In this case, the stimulus packages are expected to generate a demand for the unsold goods and drive the economy’s resource utilisation upward thereby raising output, employment and wealth levels.

If, on the other hand, there is already an excess demand for goods and services in this economy, then, the new money brought back to circulation will further raise the demand exerting pressure for prices to rise and exchange rate to depreciate.

The Three Elections have pumped Estimated Rs 24 billion

The experience in Sri Lanka shows that elections generate two types of money expenditure programmes. The first programme is the expenditure incurred by election authorities for procuring the necessary goods and services for conducting elections. The second is the campaign expenditure incurred by candidates to reach the voters.

Both types will give a new money income to people in the public service and those engaged in producing election related goods and services. This new money income will enrich the people temporarily, compelling them to spend the same on goods and services the purchase of which they would have postponed earlier due to a lack of sufficient purchasing power.

The estimates show that an island – wide election costs the government about Rs. 3 billion per election. Accordingly, the three elections held within the last 18 months or so have caused a new expenditure of about Rs. 9 billion, all distributed among those who provide election related goods and services.

Similarly, private money used for election campaigns per election has been estimated around Rs 5 billion, making a total of whopping Rs. 15 billion disbursed by campaigners.

This money specifically goes into the hands of advertisers, printers, media firms, transporters, other service providers and in certain cases where artistes have been engaged, to artistes. Money so generated for campaigns are hoarded money brought back to recirculation and is likely to stimulate demand in a big way.

A Stimulus Package over an Overheated Economy is Inflationary

Thus, outside the central bank’s monetary policy, the three elections are estimated to have pumped about Rs. 24 billion in a huge unofficial stimulus package. This is on top of the already overheated economy where there is a substantial magnitude of excess demand pressurising the domestic prices to rise and the balance of payments to show up a bigger deficit.

Since the new money pumped into the economy is expected to take about one to one and a half years to run its full transmission course, the inflationary pressures arising from this unofficial stimulus package is to exert its unintended pressure on the economy till about mid – 2011.

The signs of these ugly developments are already showing: domestic prices are rising month after month and, the central bank, in a bid to keep the exchange rate at a fixed level, is selling foreign exchange out of its reserves.

Is Double Digit Inflation within sight?

In all its likelihood, inflation will rise to double digit levels by the end of 2010 and to an unaffordable level by the end of 2011. With high inflation and unchanged exchange rate, the country’s competitiveness will begin to erode making it an importers’ paradise rather than an exporters’ fortress.

What it means is that the hard – earned macroeconomic stability which the country had toward the end of 2009 will have to be sacrificed making it necessary for Sri Lanka to restart its inflation fighting war anew.

Central Banks’ Obligation is to the Public

The society has created central banks to take an independent long term apolitical view of the economy and take appropriate policy action in advance to preserve the value of money it has created and got people to part with their real wealth in exchange of same.

The central banks’ obligation is not to the government but to the people because they have got the people to accept its paper currency with the promise that it will preserve its value.

Hence, when people realise that the value of the money in their hands is fast eroding, the bank cannot prevent them from getting into panic, nervousness and frustration. It will lead to further de–stability of the macroeconomy and such a chaotic situation will not bode well for both the government and the central bank.

Monetary Policy is a Safeguard against the Future

Hence, central banks should take monetary policy measures not on the basis of the past but on the basis of the perceptions they will make of the future developments. If a central bank has reasons to believe that inflationary pressures are building in the economy, it should start tightening the monetary policy hence forth, because any delay in doing so is like allowing a cancer to grow in the body of a healthy man.

The Sinhalese folk saying that ‘unless an evil is nipped in the bud, it will be too late later because it could not be by that time rid even with an axe’ may be a handy guidance for a well wishing central bank.

The writer is a retired deputy governor of the Central Bank of Sri Lanka. To read previous columns in the series go to the WatchTower section on the main navigation panel or click on the links below.

Since the Bank continues to engage itself in open market operations to limit the creation of reserve money, this amounts to making a ‘quantity of money adjustment’ rather than the ‘cost of money adjustment’ for realising the economic and price stability objective tasked with the Bank.

Monetary Policy is influencing both credit levels and interest rates

The Bank is charged with conducting monetary policy in the country and monetary policy means influencing both the ‘cost and the availability of money’ in order to match the country’s total aggregate demand roughly with its total aggregate supply.

Hence, by keeping the interest rates unchanged, the Bank is simply using only one of the policy parameters available to the Bank for conducting monetary policy. This may be effective at a time when prices are nearly stable and inflationary pressures in the economy have subsided.