I prepared this article in response to a discussion about the appropriate degree of tightness of monetary policy to control inflation. But the CB has now given up tight monetary policy and instead reduced the Statutory Reserve Ratio to 9.5% and liberalized access to cheap funds from the CB through the Reverse Repo window (12%). The CB seems to be reacting to a looming foreign exchange crisis due to its policy of pegging the rupee at an unsustainable and unrealistic over-valued rate on the basis of borrowed funds from international capital markets. But now, with the international financial crisis, there’s a real risk of foreign investors pulling out funds from the stock market and from the Treasury bond markets through the secondary market.

One hopes that the foreign banks abroad who have rupee accounts for inter-bank settlement will not run down these balances too. The CB is likely to discover the harsh truth that relying on short-term foreign capital movements is unsustainable and imprudent. So it is trying to raise funds through foreign borrowing from banks and we have to wish it luck for some oil bills may be falling due for payment now as the Iranian credit is over. To make matters worse, the tea prices which were booming up to now seems to be falling.

Inflation control through tight money

I have had to revise my article drastically. I had written about the Taylor Rule which is a guide to the degree of tightness or otherwise of monetary policy. The CB keeps pointing out that reserve money is well within their target and that the broad money supply growth has come down. But headline inflation has declined very marginally even on the revised Cost of Living Index and the Core Inflation Index, which is supposed to measure demand driven inflation, has actually risen. The question that was discussed at a recent forum I attended in the CB was whether monetary policy is tight enough or whether it should be tightened some more.

Captains of business present thought that monetary policy was tight enough and that any further tightening would affect their businesses adversely since it would mean higher interest rates and also a possible reduction in the supply and availability of credit to them in a context that with raging inflation they need more credit to finance their working capital. Prices of inventories have gone up and outstandings from buyers had increased, they noted pointing out that the business sector is facing liquidity shortages.

Liquidity shortage

The banks and business are facing a shortage of liquidity because of the continuing outflows in the balance of payments. When foreign exchange is paid out, it reduces the rupee proceeds of both the banks and business. But economic theory says that the remedy for an adverse balance-of-payments in the current account, even if temporarily funded by foreign borrowings, is a reduction in Aggregate Demand which requires the elimination of budget deficits which fuel such increased demand.

Under a fixed exchange rate regime as operated during the Currency Board days, any loss of Foreign Reserves would lead automatically to a reduction of the Money Supply since the currency was backed 100% by Foreign Reserves. The present situation is that owing to the drain arising from the worsening current account deficit in the balance-of-payments, the Central Bank’s loss of Foreign Exchange Reserves in its attempt to maintain the pegged value of the rupee in terms of the dollar and the foreigners pulling out of money and stock markets, the banks run short of liquidity. This would lead to an increase in the Inter-Bank interest rate at which banks lend to each other. So the Central Bank has liberalized access to the Reverse Repo Standing Facility where money is lent by it at 12% which is far below the market rates of interest.

These days there are increased drawings under this facility. Earlier the CB rightly confined access to this facility only when there was an over-all shortage of liquidity and the Inter-Bank rate would climb to unrealistic levels as in the past when it sometimes touched 90%, although it was just for a day only.

Now there is a dilemma. If the CB pumps a lot of liquidity, then the adjustment process of the balance-of-payments would be further hampered and it will also undermine the tight monetary policy. Interest rates affect the ebb and flow of foreign money.

Since our present situation is unusual, I am not advocating tightness of monetary policy. What other Central Banks do in normal circumstances is to lend only at the policy rate which is maintained above the market. This brings up the question of the appropriate rate of interest and the appropriate quantity of Reserve Money to match such a rate of interest. So how do we decide whether the rate of interest and the degree of tightness of monetary policy is adequate or not?

Policy Objectives of the CB

The original Monetary Law Act was amended by the Monetary Law Amendment Act No 32 of 2002. The original objectives of the Central Bank were revised and the CB was charged with the twin objectives of ``(a) economic and price stability; and (b) financial system stability, with a view to encouraging and promoting the development of the productive resources of Sri Lanka."

The first objective consists really of two objectives- price stability as well as economic stability. The former would mean output and employment stability and equilibrium in the current account of the balance-of-payments.  This objective ignores economic theory which says there is a trade–off between growth and price stability. The economist Meade referred to internal and external stability. The latter referred to equilibrium in the balance-of-payments on current account while the former referred to price stability or low inflation.

What happens when the two objectives of price stability and economic stability clash? Central Banks in all countries face similar policy conflicts, even if their legislative mandate is to focus solely on maintaining price stability. What they do is to assign some weight to each of the two factors - namely price stability and maintaining output. There is a conflict between the first and third objective as well. Maintaining equilibrium in the balance-of-payments may require not only the elimination of the budget deficit but also a depreciation of the rupee which raises prices and is in conflict with price stability. The problem is indeed complex. But the country now seems to be facing a foreign exchange crisis which will require priority attention

The Taylor rule

Economists have built everything from large-scale monetary policy models to simple rules of thumb to answer these questions. Of all those approaches the Taylor Rule is by far the most widely used by academics, policy makers and market practitioners. It recommends a target for the level of the nominal CB funds interest rate that depends on four factors. The first is the current inflation rate, the second is the equilibrium real interest rate. When added together, these two factors provide a benchmark recommendation for the nominal CB funds interest rate. In our case, since the core inflation rate is well over 10% and the equilibrium real interest rate at least 7% (owing to the scarcity of capital here) the rate may have to be at least 17-18%. Certainly not the Reverse Repo rate of 12%.

What should be the rate of Inflation?

The EU Stability Pact opted for 3% inflation per year. Our inflation is too high and chronic so that it cannot be brought down to 10% without serious reductions on the growth rate. Our growth rate at the present stage is driven by the war expenditure which in turn is funded by deficit finance and foreign borrowings. 

The importance of the Real Rate of Interest

The use of the equilibrium real rate in the Taylor rule emphasizes that real rates play a central role in formulating monetary policy. Although the nominal federal funds rate is identified as the instrument that policymakers adjust, the real interest rate is what affects real economic activity. In particular, the rules clarify that real interest rates will be increased above equilibrium when inflation is above target or output is above its potential. So if the equilibrium real interest rate is 7-8%, then the rate to be taken into account should be above this.

On this criterion the current policy rate of the CB is too low and should be at least 18-19%. But the times are not suitable for any tightening of monetary policy. The CB can print enough money to relieve the internal currency crisis but if it fails to borrow enough dollars we can be felled by a foreign currency crisis for it cannot print dollars to cope with the demand arising from the deficit in the balance-of-payments and from currency speculation.