Sri Lanka flirts with cost-push doctrine; blames coconuts for inflation

ECONOMYNEXT – Sri Lanka has blamed coconuts and rice for overshooting an inflation target in 2017, flirting dangerously with ‘cost-push’ doctrine despite claiming to be on track for a modified inflation targeting framework by 2020.

In 2017, the central bank generated 7.1 percent inflation as measured by the Colombo Consumer Price Index with 12-month inflation peaking at 7.8 percent in October, overshooting its wide target of 4-6 percent.

A country-wide National Consumer Price Index measured the inflation generated by the central bank at 7.1 percent in calendar 2017 peaking to 8.8 percent in October.

Coconut Inflation

"This was entirely due to supply side disruptions, due to the weather," Central Bank Governor Indrajit Coomaraswamy told a business forum organized by the Ceylon Chamber of Commerce.

"Food price inflation reached over 13 percent. It peaked about 3 months ago. Now there is very little that monetary policy can do address supply disruptions driven increases in inflation. That the government has to address through increasing supplies."

Governor Coomaraswamy blamed the inflation on coconuts and rice, claiming that the central bank can only control inflation measured by a ‘core-inflation’ index which he said was generated by demand. Core-inflation is an index that strips out items like oil and food and has little to do with reality.

"Interestingly this 13 percent food price inflation was very largely due to two items; rice and coconuts," Coomaraswamy said.

"The sharp increase in rice and coconuts contributed to the food price inflation."

Governor Coomaraswamy said the central bank will be closely watching inflation expectations and wage developments in the first quarter, as the two will contribute to inflation. By 2020 Sri Lanka was planning to move to a modified inflation targeting regime.





Core-inflation targeting

Inflation targeting as devised by the Reserve Bank of New Zealand explicitly promises to control a so-called headline inflation rate which people feel.

Critics say if the central bank is targeting core-inflation, it may as well give up on inflation targeting right now.

In an earlier media conference in early January, Deputy Governor Nandalal Weerasinghe took pains to raise confidence in the ability of the central bank to reduce inflation, following a discussion of coconut and rice based inflation.

"Just to add a clarification on inflation targeting, obviously we will target the average headline inflation, basically that is what matters to the public," Deputy Weerasinghe told reporters.

"But these short term impacts of supply side shocks are expected to be one-off," he said. "So if this supply side constraint has increased inflation to around 7.6-8 percent – if that is the supply side constraint it will have to come down.

"It has to be a one-off event. If it is not going to come down obviously we have to take action. This is what indicates that it is not a supply side constraint, but that there is a demand element so we have to tighten monetary policy. So I am not saying we are targeting core-inflation."

Cost-push Mercantilism

Classical economists who countered Mercantilists have long pointed out that the price of one or two goods going up cannot generate a rise in the general price level as increases in one or two goods reduces the demand for other goods in the absence of monetary accommodation.

A part of the problem is the 12-month cycle of inflation that central bank’s watch, though the effects of money printing and currency depreciation may last longer. Any inflation created in the previous 12-months is a ‘bygone’.

Sri Lanka has seen higher levels of ‘core-inflation’ than headline or almost around the same level in the recent past.

Since December 2014, from around the beginning of the current credit cycle and massive money printing started, headline inflation measured by a revised CCPI had gone up 17.04 percent with the index rising from 105.0 to 122.9 points.

The CCPI – core index meanwhile went up by a higher 17.7 percent. In the National Consumer Price Index, the headline inflation was shown to go up by 16.57 percent and core only marginally lower at 16.02 percent.

That inflation is due to some cost-push factors including wages, and not due to monetary accommodation has been a favourite argument from the time of classical Mercantilists, critics say.

Attributing cost-push factors to inflation ranges from Sir James Steuart in 1767 (Inquiry into the Principles of Political Oeconomy) and the ‘anti-bullionists (Real Bills Doctrine) in the early 1800s during the Napoleonic wars and a crop failure.

In the 2007/2008 commodity bubble fired by the Fed, cost-push arguments again came to the fore, with claims in the popular media that there was a ‘food crisis’, until the US credit bubble finally burst under a load of bad loans, causing a deflationary collapse in prices.

Monetary Policy Neglect

In 2015 to early 2017 the central bank printed 630 billion rupees pumping liquidity to fire an unsustainable credit bubble and to sterilize forex sales (a process some economists call ‘amplification’), generating a balance of payments crisis, and losing about 4.0 billion US dollars in forex reserves.

The currency collapsed from 131 to 153 levels – which is de facto anchored to the US dollar through a dirty float or soft peg – pushing the prices of all traded goods up and altering the price structure in the economy.

Analysts have warned that depreciating the currency to target a real effective exchange rate index will further boost inflation.

However currencies in countries like Malaysia and China (which fell in 2016 pushing up nominal effective exchange rates) are now strengthening, which may persuade the central bank not to weaken the rupee further.

Economists have pointed the reliance of non-monetary causes (monetary policy neglect hypothesis) are dangerous as such ideas contributed to the massive post World War II inflation and which culminated in the so-called ‘Great Inflation’ of the 1970s after the Bretton Woods finally collapsed.

In contrast central banks in Japan and Germany, which suffered from hyperinflation during World War II, were the first to combat high inflation and end strikes and wage demands. (Colombo/Jan29/2018)

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