Header Ad

Sri Lanka for flexible inflation targeting

ECONOMYNEXT – Sri Lanka wants to do ‘flexible inflation targeting’ Deputy Central Bank Governor Nandalal Weerasinghe said as neighbouring India proposed deadly rules potentially giving more powers to rulers to manipulate interest rates and generate economic instability.

Under a successful ‘inflation targeting regime’ a central bank, which has a state monopoly in money printing is forced to stop generating inflation at an agreed level with the state and the Central Bank Governor is made to bear the sole accountability.

Under such a system, the exchange rate floats and money is printed only through open market operations at a targeted policy rate. When inflation goes up the interest rate is raised so that the lower amounts of money is printed through the policy rate system.

Flexible Targeting

But Weerasinghe said there was a current international debate whether central banks should be made responsible only for inflation or their goal should be flexible.

"You need to maintain some flexibility so that you are not only targeting one specific variable," Weerasinghe told a business forum organized by the Ceylon Chamber of Commerce.

"We do not want to call if inflation targeting. We want to call it flexible inflation targeting."

Some classical economists have said that the current global downturn that came in the wake of a massive bubble fired by the US Federal Reserve which had a dual mandate of inflation and employment had created confusion and strengthened the hand of interventionists and money printers.

Weerasinghe was responding to a question from the forum as to how Sri Lanka could move towards an inflation targeting framework when it had a ‘soft-peg’ with the US dollar an inherently unstable monetary arrangement.

Under such a system, the Central Bank tried to follow domestic inflation index (a domestic anchor) by targeting interest rates but also targeted an exchange rate (an external anchor) which involved printing money and controlling exchange rate.

Advertisement

 

 

 

Such a regime cannot be perused when credit growth picks up, and rates are manipulated down, resulting in frequent balance of payments trouble and high inflation.

Weerasinghe said Sri Lanka already had features of an inflation targeting regime such as policy rates and was moving towards a more formal system, though the current system could be defined more correctly as a ‘monetary targeting’ regime.

"If you look at the way we implement monetary policy now, it has a lot of good features of an inflation targeting regime," Weerasinghe said.

"If you compare our monetary policy implementation versus that of Philippines or Indonesia, I do not see a major difference. They are also intervening in the currency market as well.

Economists have said that Indonesia suffers from the same problem dogging Sri Lanka which leads to high inflation and balance of payments trouble, by juggling with dual anchors.

Weerasinghe said it was not possible to stop intervening in currency markets because Sri Lanka was small and its forex markets were not developed.

"Currency stability is important when we have a small market. If we have a developed currency market like in New Zealand then we can just forget about it."

Accountability, Clear Objective

New Zealand is credited with ‘inventing’ formal inflation targeting regimes where an agreement is signed with the Finance Minister and the Central Bank on a target.

If the target is not met the Governor is made responsible and not a committee, so that there was no possibility of ‘passing the buck’. After generating high levels of inflation central bankers also pass the buck claiming that prices rose due to ‘cost-push’ inflation and other prevarications.

 

Murray Sherwin, a Deputy Governor Reserve of the Bank of New Zealand told a regional economics conference in 2000 that the success of the program did not come from any sophisticated money economics theory but basic management accountability.

"In New Zealand, the development of inflation targeting owed a lot more to the Harvard Business School than to the Chicago monetarists we are sometimes accused of following," he explained.

"The Reserve Bank of New Zealand was just one of a number of state agencies in the process of undergoing reform in the late-1980’s, and the guiding principles for those reforms came from the text books on corporate governance rather than from those on monetary policy."

Sherwin said a state agency must have a clear objective, clear divisions of responsibility between decision makers and "specify clear accountabilities so that those given the authority to make decisions may be held firmly accountable for the quality of their decisions."

Global inflation and currency instability became a serious problem after the Federal Reserve was set up as a semi-state agency in 1913 and Britain suspended gold convertibility and the Treasury started printing money outside the then-private Bank of England to finance World War II.

Inflation became a bigger problem after the Second World War when many central banks were nationalised and public suspicion and parliamentary checks that existed on private banks disappeared and money was printed for ‘growth’ and other political objectives.

 

Indian Debate

There is a fierce debate in India over attempts by the Modi administration to take the rate setting power (money is printed through domestic operations of a central bank by the policy rate) away from the governor through a committee made up of majority of government members.

The Modi administration want to take away the rate setting responsibility away from the Central Bank Governor and give it to a seven member committee where only three will be from the RBI.

Economists fear that any administration will then be able to print money at will pursue ‘growth’ and other political objectives and create monetary mayhem and economic instability as they did between independence and 1991.

The Indian rupee, was the ‘dollar of South Asia and Middle East’ during the British Empire but it became a non-convertible currency after the Reserve Bank of India was nationalized and money was printed for Soviet style 5-year plans under the Prime Minister Jawaharlal Nehru.

Middle Eastern nations then set up their own currencies, many of which are still strong today.

The rupee became strong and inflation fell only in 1991, when the Treasury secretary’s role in the monetary policy setting committee was reduced ending so-called ‘fiscal dominance’ of monetary policy.

Some economic analysts say the renewed international attacks on inflation targeting as well as developments in India are simply re-incarnations of old interventionist ideas such as the ‘real bills doctrine’ of John Law which when put into practice generated the South Sea bubble.

Tags :