Flexible inflation targeting subject to debate: Sri Lanka CB Governor

MERCANTILIST MONUMENT: The short lived Gulf Rupee, printed in a knee-jerk fix as the Indian rupee collapsed, was eventually dumped by Middle Eastern nations that used the specie-backed British colonial rupee. Some notes are now traded at high prices as collector’s items. It stands as a monument to the lack of classical economic knowledge and widely held Mercantilist belief systems in South Asia.

ECONOMYNEXT – Sri Lanka will improve its policy framework for monetary stability with the ‘flexible’ inflation targeting that is being followed being subject to ‘intellectual debate’ Central Bank Governor W D Lakshman has said.

“The monetary policy framework of the Central Bank, in the recent past, has been one of flexible inflation targeting,” Governor Lakshman said outlining a monetary policy roadmap for 2020.

“This is a subject of ongoing intellectual debate around the world.

“The Central Bank will continue to improve its policy framework in this area, with due emphasis on monetary stability for real sector growth.”

Twin Objectives

Sri Lanka’s new administration has not yet endorsed a new Monetary Law which sought legalize inflation targeting, but would also institutionalize a so-called ‘flexible exchange rate’ which in the light of recent experience has turned out to be a highly unstable soft-peg subject to collapse.

Meanwhile Governor Lakshman said growth was as important as low inflation.

“The maintenance of mid single digit levels of inflation is an essential component of macroeconomic stability,” he said.

“It will protect vulnerable sections of the population; equally, perhaps more, important at times of low inflation, is shared, employment-creating production growth.”

“The developments in the past few years have shown that, at times, there was a tradeoff between macroeconomic stability and economic growth.”

“While stability is important, a people-centric government cannot ignore its social and human development objectives, especially when Sri Lanka is ready for its economic takeoff.”

“We intend to pursue our efforts to find solutions to balance these conflicting objectives of public policy, without compromising economic and price stability and financial system stability.”

Under ‘flexible’ inflation targeting Sri Lanka also appeared to have targeted an output gap, based on public pronouncements and rate cuts at different inflation points analysts have observed.

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Analysts have faulted the International Monetary Fund for giving tools to Sri Lanka to calculate an output gap, leading to further dilution of genuine inflation targeting which was already constrained by the ‘flexible exchange rate’.

They have pointed out that inflation targeting was not possible without a floating exchange rate and dropping attempts to target output gaps (a dual mandate). Similar attempts, they pointed out led to the collapse do the US dollar and Bretton Woods in 1971-1973.

A dual mandate in the US Fed have also been partly blamed for the 2007 bubble whose collapse led to the so-called ‘Great Recession’ as well as inflation targeting itself.

The US core inflation index which removed fuel and food – some of the commodities that respond fastest to weaknesses in the dollar – as well as the CPI-U index itself which is also designed to understate price levels, had misled policymakers, critics had said.

Sri Lanka’s central bank was set up in 1951 with money printing powers, abolishing a hard peg with the Indian rupee at 1 to 1 (around 4.70 to the US dollar) which in turn was pegged to sterling at about 13 and half.

The Worst Performer

Since then it had been the worst performing monetary authority in South Asia and Gulf nations which also used Indian rupees at the time.

Sri Lanka’s rupee has collapsed steadily from 4.70 to the US dollar when the agency was set up to 182 to so far, in the worst performance in South Asia after Pakistan which had fallen to 154 to the US dollar from 4.70.

India’s rupee has fallen to 72, from 4.70. Bangladesh has had a long period of stability in the last decade setting the stage for growth.

Maldives is the best monetary authority in the region in absolute measurement with the Rufiyaa falling to 15.46, with the archipelago achieving the highest per capita income with less active policy.

Gulf countries like Dubai and Oman which also had Indian rupees, that set up their own monetary authorities without activist policy, are employing large numbers of other South Asiams with over 100 percent employment (as is the Maldives).

After independence from British rule and full nationalization of the Reserve Bank of India, the rupee started to collapse as money was printed to finance Nehru’s Gosplan style 5-year plans. Only one economist B R Shenoy objected.

Read Shenoys note of dissent here : A NOTE OF DISSENT ON THE MEMORANDUM OF THE PANEL OF ECONOMISTS

With forex shortages triggering gold smuggling India introduced the ‘Gulf Rupee’ in 1957, but failed to have credible monetary policy to back it, leading to many Middle Eastern states setting up their own currencies, which brought them monetary stability, while India went down with the path of forex and trade controls and the Hindu rate of growth.

Kuwait in 1961, Bahrain in 1965 and Dubai/Abu Dhabi which was part of the so-called Trucial States, and set up fairly hard pegs (currency board-like systems), have grown strongly with long periods of monetary stability.

Neighboring oil-rich states like Iran with activist central banks continue to have worse monetary instability than Sri Lanka.

Sri Lanka suffered some of the worst monetary instability in the 1980s and 1990s, with inflation around 20 percent, a cycle which was broken by then Governor A S Jayewardene, who did not practice Keynesian interventionism.

Deflationary Collapse

After the 2018 currency collapse, inflation has been sharply below the 20 percent inflation seen in the 1980s and early 1990s. Tightened US policy in 2018 also reduced commodity prices in early 2019.

Governor Lakshman said ‘single digit’ inflation was an achievement.

“On the inflation front, the country has experienced single digit levels of inflation for the past eleven years,” he said.

“This is an achievement we in the Central Bank are rightly proud of, given its mandated role to ensure economic and price stability in the country.

“Sri Lanka appears to have broken off from its post-1977 history of highly volatile, often double digit levels of inflation.

“Behind these inflation achievements however, lies conditions of subdued aggregate demand. This implies a negative output gap that needs to be filled urgently by utilising the available policy space.”

Others however say a slower growth with a mild inflation spike – close to a so-called deflationary collapse – is a relative small price to pay for to emerge from a soft-peg or flexible exchange rate crisis.

Failure to reign in liquidity in time, leads to ‘inflationary collapses’ or meltdowns in the style of Argentina, or Indonesia during the East Asian crisis, which result steeper currency falls, absolute economic contractions and possible sovereign default of forex debt.

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With Sri Lanka’s central bank no longer directly intervening in Treasury bill auctions, activist monetary policy now comes from liquidity injections through open market operations and so-called ‘operation twist’s like exercises.

“In the monetary policy conduct, active open market operations (OMOs) will continue to serve as the major policy instrument to manage domestic money market liquidity,” Governor Lakshman said.

“Short term market interest rates will be guided to remain at the desired level within the Central Bank’s policy interest rate corridor.

“Several initiatives have been taken to improve the smooth functioning of the domestic money market.

“Going forward, the Central Bank will continue to ensure that adequate liquidity in the domestic money market is maintained.

Governor Laksman however did not cut rates in the last week of December, as widely expected by markets. (Colombo/Jan07/2020)