ECONOMYNEXT – Two Sri Lanka legislators warned on targeting potential output despite macroeconomists having succeeded in inserting the clause into an International Monetary Fund backed law given the experience with recent currency crises triggered by the agency.
At the parliament’s Committee on Public Finance, Chathuranga Abeysinghe, raised a query about whether the independent central bank has a goal on growth.
Conflicting Objectives
Growth was in the monetary law as a ‘secondary objective’ Harsha de Silva, who chairs the Parliament’s Committee on Public Finance said.
“In pursuing the primary objective referend to in sub section 01 which is price stability, the central bank shall take into account inter alia the stabilization of output towards its potential level,” de Silva told, reading out the newly crafted controversial monetary law.
“That is a double-edged sword there. Because what is the potential output, and then you create an output gap. Then you say ‘I need to fill this output gap, so, therefore I need to reduce interest rates to make it more ‘accommodative’
“That will go the other way and hit interest rates and inflation rates. As for your question honorable minister, it is there.”
The dreaded word ‘accommodative’ has now started to appear in central bank language.
Stability
Up to now rates fell despite (or because of the currency stability) deflationary policy where the floor rate was set above what is required to keep the external sector in balance.
The rates fell as energy prices were market priced allowing state energy enterprises to repay debt, the government taxed the people and generated a primary account surplus requiring only interest to be rolled over (as paper) as long bids to auctions were not rejected.
Sri Lanka’s economic officials and then political leadership also decided not to restructure domestic debt leading to a 1000 basis point fall in rates in one day as confidence improved.
The central bank’s deflationary policy which initially reduced private credit and later a recovery of lost value of salaries and savings through a currency appreciation did the rest. Countries with strong currencies without anchor conflicts have low nominal rates and vice versa.
Targeting potential output, which requires inflationary open market operations, lead to currency crises, higher inflation and destroys key attribute of money as a unit of account, a store of wealth as well as a means of deferred payments.
Growth is a Political Objective
“I do not think it is the central bank’s job to look at output targeting,” opposition legislator Kabir Hashim said.
“Providing stability is their job. It is the government’s job to talk about getting the economy growing. That is why there is a government.
“How do you do that? There must be political stability, people must feel that they can invest that is why will drive the economy more than putting artificial pressure.
“We made the mistake in 2018 and put pressure and the exchange rate dropped from 150 to 184 rupees within a month or so.”
However in the past two years, in keeping prices down and undershooting the central bank’s 5 percent inflation target,
“What the Governor and the team have done in the past two years is exceptionally great,” Hahim said.
“Inflation is the worst tool that can make people poorer and miserable.”
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Anchor Conflicts
Sri Lanka has exchange controls (as well as trade controls) which means the operating framework of the central bank is fundamentally flawed, and there are inherent anchor conflicts which trigger forex shortages, which also trigger trade controls.
From 1950, it was the belief that Sri Lanka could run a credit cycle longer than the Fed with independent monetary policy leading to the us of foreign reserves for imports, instead of matching all inflows in near real time through the credit system as happened earlier
After 1978 it was a believe that a statistical money supply could be targeted without a floating exchange rate. Now it is a believe that inflation could be targeted without a clean float.
Under clean float also all outflows, whether current or capital are matched in real time through the credit system without any foreign reserves.
Abundant Reserves Regime
The 2018 crisis in particular took place despite taxes being cut and the budget deficit being brought down and fuel also being market priced, showing that there was neither de jure nor de facto fiscal dominance.
Central banks that get IMF technical assistance and ha despite now operate on a doctrine called ‘exchange rate as the first line of defence’ which means the ‘interest rate is the last line of defence’.
Rates are allowed to go up after the currency collapses or forex shortages trigger parallel exchange rates (the domestic currency’s attribute as an international medium of exchange deteriorates) as was seen after the end of the civil war in 2012, 2016, 2018 and 2022.
If the ‘interest rate is the last line of defence’ as de facto promoted by the International Monetary Fund and suppressing rate as long as possible is the overarching doctrine for US style macroeconomic policy, then there is a question of why central bank independence is needed in the first place, critics say.
In 2018, de Silva who was mister pleaded with the central bank to allow rates to go up to the ceiling of the corridor as the exchange rate came under pressure.
Under a ceiling rate regime, barely enough money is printed to mis-target rates in what is called a ‘scarce reserve regime’.
However, if a mid-corridor or single policy rate is targeted, large volumes of excess liquidity is needed in resulting in what is called a ample or abundant reserves framework is created, making currency crises almost inevitable.
“If it is hitting the ceiling and you’re not injecting money at below 8.5 percent, then it’s alright and there’s no need currently to increase your policy rates,” De Silva said in 2018.
“But at least let the overnight rates be within the higher margin of the policy rate. It’s prudent.
“Of course it’s going to have a negative impact on growth, but that is what we have to give to have some sort of stability on the exchange rate.”
The single policy rate has now been gazetted under the new monetary law.
Stabilization Crises
An elected government will be thrown out by the electorate either during the inflation crisis forex shortages that come when growth is with rate cuts or the stabilization crisis that follows after the currency collapses, real incomes also fall and interest rates shoot up.
When real incomes collapse and rates go up, SMEs as well as over-leveraged large businesses also collapse leading to bad loans in banks. If banks start to collapse, another chain reaction is set off.
During the so-called Yahapalana era the interest rate shooting up effect was moderated by heavy foreign borrowings at each currency crisis, though output declined steadily as stabilization crises came at increasingly shorter periods.
The government that was elected after the economic policy of the then administration was discredited by the 2017 and 2018 inflation and stabilization crisis (also called stop-go cycles) and average growth declined compared to war time years.
The administration that came to power cut rates and taxes claiming that that there was a ‘persistent output gap.’ Cutting rates and valued added tax (macro-economic policy) was pioneered by Oxford educated UK chancellor Anthony Barber.
However, despite the experience, which is also the experience of countries that target employment, potential output was put in the IMF-backed monetary law and is now referred to in in monetary policy statements.
In the Fed, the employment is also referred to in monetary policy statements, unlike in the Great Moderation period of falling commodity and food prices, when Fed Chairmen ignored growth.
The 2018 crisis in particular took place despite taxes being cut and the budget deficit being brought down and fuel also being market priced, showing that there was neither de jure nor de facto fiscal dominance. (Colombo/Feb02/2025)
