Ms. Manesha Weerasuriya presented a paper at the Annual Sessions of the Economic Association making a case for inflation targeting by the Central Bank instead of the present monetary targeting. Let us examine the proposition.

The Central Bank will target a definite inflation percentage for a given period, which will have to be measured by some Price Index - a Cost of Living Index or the Core Inflation Index prepared by the bank but not published. It must decide on the level of inflation to be targeted. Remember that economists do not advocate zero inflation. The EU opted for 3% and generally developed countries fixed on 2-3% per year. Since our inflation is quite high (25%) the Central Bank must also decide over what horizon it should bring down inflation and in what sort of steps. It cannot bring it down to 3% in one year without serious repercussions on output and growth.

The inflation target must then be transformed into an operational target. The Central Bank (hereafter CB) is presently targeting Reserve Money and through it the Broad Money Supply. Most countries have given up such an operational target because it has been found to be ineffective. They resort to increases in the interest rate instead of the Reserve Money and allow the Reserve Money to adjust to it. Studies in other countries have shown that the relationship between Reserve Money and Broad Money is not as simplified as in textbooks on Monetary Economics. On the contrary, the Money Supply seems to be exogenously determined and that Reserve Money merely adjusts itself to the Broad Money. But this requires another article.

The CB proclaims from the housetops that it’s Reserve Money and Broad Money growth targets have been achieved. True. But it refers to the flow concept and not the stock concept. The stock of money created over the years, particularly during the regimes of CBK and today, is still around to fuel demand; and it is this excess liquidity circulating in the country that has to be dealt with.  Without that there is little hope of bringing down inflation caused by demand pull.

Most central banks have given up targeting other objectives like output or growth and employment and focus on price stability. They concentrate on this single objective but this poses a problem for the ruling politicians who do not wish to see any policy leading to a reduction in economic growth. But economists say there is a trade-off between inflation and output and employment.  They say high growth will inevitably lead to high inflation (except where the actual growth rate is below the potential growth rate) because the aggregate supply of goods and services cannot increase unless there is spare capacity in the form of unutilized or under-utilized plant and machinery.

This applies to developed industrial countries but not to developing countries where any increase in output (growth rate) is entirely due to good weather providing higher agricultural output and an increase in the application of labor rather than to any improvements in productivity of labor. In the new knowledge economy which prevails in the developed countries, it has been argued that there can be growth without inflation because such growth is accompanied by improvements in the productivity of both labor and capital. Even this thesis has been challenged recently and monetary authorities in the UK and the EU but not in the USA (where increases in labor productivity have been significant) have given priority to the control of inflation despite their economies showing signs of decline in growth (recession).

The question is whether developing countries like ours can afford to take a cut in the growth rate in order to reduce inflation. The Monetary Law Act amendments introduced during Ranil’s government did not make price stability the only objective of the Central Bank but added Output increases also. Hence the Central Bank has to decide what sort of trade-off it is prepared to accept in the inflation versus growth objectives. The ruling politicians will not agree to any reduction in growth particularly in the war expenditure which is counted as GDP. But the CB has to accept the fact that the high public expenditure and the accompanying higher growth necessarily entail the present high level of inflation - a consequence of such growth.

The higher growth also increases the deficit in the current account in the balance-of-payments. The ever increasing current account deficit is funded by the inflow of foreign money but this is entirely in the form of short term lending to the government either directly or via the purchase of Treasury Bills & Bonds as well as portfolio investment flows into the stock market. With the steep decline in the stock market there is likely to be net outflow on this account now. But such short-term funds can flow out as easily as they came in via sales of Treasury securities in the secondary market and remitting out the proceeds if there is a loss of confidence in the Government or the country due either to a reverse in the war or due to the sudden depreciation of the rupee (presently it is pegged to a fixed value by the Central Bank). Then short term investments would no longer be attractive. Only time will show the likelihood of such an outcome.

Why inflation targeting won’t work

What our economy needs is stabilization first before growth. The large monetary overhand caused by years of deficit budgeting funded by the CB and the commercial banking system has made it impossible to control inflation. It is true that inflation targeting has been successful in the developed countries. But the developing countries are different. Firstly the economic structures are different - ours being largely agricultural and service oriented while the developed countries are industrial. There are differences also in the respective economic environments. The developed countries by and large allow markets to operate but we don’t and we interfere in the operation of free markets. A glaring example is the labor market. So the anticipated results will not be forthcoming.

Next we have a government that doesn’t care tuppence for fiscal prudence and is in open violation of the provisions of the Fiscal Management (Responsibility) Act of 2003 which prescribed limits for the budget deficit and the outstanding government debt. In the developed countries there is much greater appreciation of the needs of fiscal prudence. Further, 35% of the Gross Domestic Product is accounted for by the government and the government is quite oblivious to the impact of its activities on interest rates or the exchange rate. The Government will not bother about the higher rate of interest to be paid as a result of the tighter monetary policy.  So the entire burden of curtailing credit falls on the private sector businesses- the only productive growth sector in the economy.

Businesses can’t do without credit and most of it is from the banks.  At a time of high and continuing inflation the need for credit actually increases because prices increase push up working capital requirements. Imagine what would happen if the CB curtails credit drastically. It will bring on a contraction in business which will reduce output and employment in the private sector. So the CB cannot afford to tighten credit too much. In any case if it allows a free flow of foreign capital inflows, it will lose control of the interest rate despite sterilization which has its limits. 

When the CB pegs the exchange rate to a fixed value as it is doing now, it will necessarily have o subordinate monetary policy to the Exchange Rate objective. Then it is not in a position to target inflation or any other economic variable. When the government does so, say by raising wages, it is undermining the Exchange Rate objective.

Studies in Hungary (vide András Komáromi: The effect of the monetary base on money supply – Does the quantity of Central Bank money carry any information?) MAGYAR NEMZETI BANK Bulletin June 2007

1. It is clear that the Households and the Corporates decide on the  instruments (e.g. shares and government securities) and the portion to be kept in instruments having the functions of money;

2.  economic agents decide on the instruments they want to keep their money in on the basis of their respective liquidity, interest rate and risk, thereby shaping the size of the money aggregates (M1, M2, M3);

3. The structure of instruments brought about by the portfolio decisions determines the quantity of reserves and the currency in circulation, i.e. the monetary base.