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 referred 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 said, reading out the newly crafted monetary law which has created some controversy.
“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 central bank’s 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. Instead, the central bank to the hit to meet a statistical requirement of the IMF’s debt sustainable analysis.
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, leads to currency crises, higher inflation and destroys key attributes 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, having been twice bitten while in government.
“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 it 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, keeping prices down and undershooting the central bank’s 5 percent inflation target was a big achievement, he said.
“What the Governor and the team have done in the past two years is exceptionally great,” Hashim 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 believed that a statistical money supply could be targeted without a floating exchange rate. Now it is believed that an inflation which is about three times the level that is found in stable countries 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 System
The 2018 crisis in particular took place despite taxes being hiked and the budget deficit being brought down and fuel also being market priced, showing that there was not even de facto fiscal dominance.
In 2018, de Silva who was a minister pleaded in a public seminar 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 essentially for clearing purposes, (accounting for small timing differences in mis-matched loans and deposits) in what is called a ‘scarce reserves system’. The policy rate – if there is one – is therefore limited to signalling.
However, if a mid-corridor or single policy rate is targeted, large volumes of excess liquidity can be injected resulting in what is called an ‘ample’ or ‘abundant’ reserves system, as rates are pushed towards the floor.
Banks then lend the rupee reserves as actual loans without deposits, making currency crises almost inevitable in a reserve collecting central bank which ‘manages’ the exchange rate.
In October as interbank bank market rates were pushed with excess cash at a pips above the floor rate, the central bank was urged not to print money by analysts who wanted sound money.
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Sterilizing reserve sales has the exact same outcome.
“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 as the currency collapsed around their ears.
“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.”
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The single policy rate has now been gazetted under the new monetary law.
With inflation going out of control, including by the ECB, which also shifted to a de facto floor system, initial push-back is coming in Europe from Bundesbank and BIS officials.
Central banks that get IMF technical assistance now operate on a doctrine called ‘exchange rate as the first line of defence’ which means in practical terms that the ‘interest rate is the last line of defence’, critics say.
After injecting money, rates are allowed to go up after 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, 2015, 2018 and 2020.
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 of US-style macroeconomic policy, then there is a question of why central bank independence is needed in the first place.
Stabilization Crises
An elected government can be thrown out by the electorate either during the inflation crisis that comes after rate cuts or the stabilization crisis that follows after the currency collapses, when real incomes deteriorate 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 UK chancellor of the exchequer Anthony Barber, leading to high inflation and widespread strikes.
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 monetary policy statements.
In the Fed, 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 employment.
(Colombo/Feb02/2025)
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