Objectives of monetary policy

By R.M.B. Senanayake

The ultimate objective of economic policy is, generally speaking, to improve public welfare. This could involve, for example, efficient resource utilisation, full and stable employment, high and sustainable economic growth, price stability or a fair distribution of income. The original Monetary Law Act which set up our Central Bank did in fact specify such objectives. Subsequently in 1998 or so the objectives were modified as

(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”.

Thus unlike central banks elsewhere the single objective of maintaining price stability was not made the sole objective for it is charged also with maintaining economic stability. But it can do little or nothing to maintain economic stability in a small open economy like ours.

Trying to do too much

So our Central Bank is trying to do too much. Monetary economists have shown that the Central Bank can do very little with the real economy (as opposed to the money economy) on variables like output or employment. It is also accepted by central banks in many countries both developed and developing that the only objective that any central bank can hope to control is the general price level.

Any other objectives like promoting faster economic growth or maintaining the exchange rate fixed by pegging it to gold or the US dollar are mutually contradictory with the price stability objective. A fixed exchange rate means that the domestic money supply will vary with the balance of payments position.  Under the Currency Board arrangement it was the current account and the balance of payments that determined this. But nowadays there are free inflows of foreign capital either to the private sector through the stock market or to the government bond market or directly to the Government as under bilateral aid agreements and then the domestic money supply will vary with the over-all balance of payments position of surplus or deficit.

The Central Bank projects a surplus in the over-all balance of payments of US$ 350 million or Rs. 38,500 billion. Net credit to the Government from the banking system is expected to be Rs. 42 billion. The projected increase in broad money is 14.5% for 2011. But it 2009 it grew by 19.9%. The bank says it will maintain exchange rate stability, which means it will more or less peg the rupee to the current rate of exchange for the rupee.

Are these objectives compatible?

Economists nowadays refer to the impossible trinity of free foreign capital inflows, a fixed exchange rate and an independent monetary policy. One or the other has to give way they say. For example the maintenance of the rupee exchange rate means that the domestic money will increase with the inflows of foreign capital.

The bank projects an inflow of US$ 1.7 billion to the Government and US$ 1.5 billion to the private sector. Portfolio investments are also expected to rise. The Central Bank has also to accommodate the borrowing requirements of the Treasury by ensuring that it gets Rs. 42 billion extra.

This means it must expand the reserves to be held by the commercial banks and furnish the extra liquidity needed by the banks particularly the two State banks which lend to the Government. How is all this compatible with the goal of maintaining low inflation? Before that, why is inflation considered bad or harmful?

Here is what the IMF states about inflation: “Inflation is bad news. Besides distorting prices, it erodes savings, discourages investment, stimulates capital flight (into foreign assets, precious metals, or unproductive real estate), inhibits growth, makes economic planning a nightmare, and, in its extreme form, evokes social and political unrest.” The IMF in the same article ‘Inflation Targeting as a Framework for Monetary Policy’ by Guy Debelle, Paul Masson, Miguel Savastano, and Sunil Sharma points out that in the past “experience and convenience have induced most of them (central banks) to conduct their monetary policy by relying on intermediate targets such as monetary aggregates or exchange rates. But now several countries both in the developed and developing world have adopted inflation targeting instead.” They may decide on a rate of inflation and some tolerance limits say +or – 1%.

Why did these countries choose inflation targeting over alternative policy frameworks?

The IMF article says: “First, the authorities in these countries have decided that achieving price stability – a low and steady inflation rate – is the major contribution that monetary policy can make to economic growth. Second, practical experience has demonstrated that short-term manipulation of monetary policy to achieve other goals – higher employment or perhaps enhanced output – may conflict with price stability. Some economists believe that an attempt to achieve several economic goals gives monetary policy an inflationary bias.

“Central banks certainly appear to get more public criticism for raising interest rates (a customary anti-inflationary tactic) than for lowering them, and they are subject to constant pressure to stimulate economic activity. Inflation targeting in principle helps redress this asymmetry by making inflation – rather than employment, output, or some other criterion – the primary goal of monetary policy. It also forces the central bank to look ahead, giving it the opportunity to tighten policies before inflationary pressures become intense.”

Under inflation targeting, the Central Bank forecasts the future path of inflation; the forecast is compared with the target inflation rate (the inflation rate the Government believes appropriate for the economy); the difference between the forecast and the target determines how much monetary policy has to be adjusted. Countries that have adopted inflation targeting believe it can improve the design and performance of monetary policy compared with conventional procedures followed by central banks.

Should we adopt inflation targeting?

The Central Bank says in its Road Map that inflation will remain at single digit level – between 1% and 9%. A former Governor A.S. Jayawardene in a previous Annual Report said inflation targeting could not be adopted here because of the fiscal deficits. True of course, but only partly. What is required is independence from fiscal dominance. What is required for inflation targeting is also given in the same IMF article.

Inflation targeting requires two things. The first is a central bank able to conduct monetary policy with some degree of independence. No central bank can be entirely independent of government influence, but it must be free in choosing the instruments to achieve the rate of inflation that the government deems appropriate.

Our Central Bank lacks independence since the Secretary to the Treasury is on the Monetary Board (no reflection on the particular officer who holds the post). There are other factors inhibiting independence too. The Central Bank could come under the dominance of the Treasury since it is also managing the public debt and handling the borrowing requirements of the Treasury. In this agency function it is required to borrow cheaply, supply the borrowing needs of the Treasury and lengthen the maturity of the debt. These fiscal policy considerations should not however dictate monetary policy.

“Freedom from such fiscal dominance implies that Government borrowing from the Central Bank is low or nil, and that domestic financial markets have enough depth to absorb placements of public debt, such as treasury bills. It also implies that the Government has a broad revenue base and does not have to rely systematically and significantly on revenues from seignior age – revenues that accrue to the government from having the monopoly on issuing domestic money (the difference, for example, between the cost of paper and printing and the face value of a Rs. 1,000 currency note which can represent perhaps as much as 99% profit for the Government).”

What this says in simple language is that monetary policy would then be used to provide cheap money for the Government.

If fiscal dominance exists, inflationary pressures arising from high budget deficits will undermine the effectiveness of monetary policy by obliging the Central Bank to accommodate the demands of the Government, say, by easing interest rates or providing advances to the Treasury or subscribing to Treasury securities.

The IMF article also points out that a country that chooses a fixed exchange rate system subordinates its monetary policy to the exchange rate objective and will be unable to operate an inflation-targeting system, especially when capital can move freely in and out of the country.

(The writer is an economist and is the General Manager of a Colombo-based stock brokering firm. You can reach him via [email protected].)