Development role of Central Bank under new Central Bank Act: Part II

Since the Central Bank has done its job, the real sector development should come from the real sector participants, namely, households, businesses, and the Government

Story so far

In Part I of this series,1 we looked at how the public and politicians viewed the central bank as an institution that is responsible for steering the real economic growth of the country and a cash cow for funding the profligate expenditure of the government. This misconception has led both parties to believe that the low or negative economic growth has been the fault of the central bank. However, the central banks are expected to help a country to have high economic growth by maintaining price stability through appropriate monetary policy action. That monetary policy action requires a central bank to increase money supply and, through that measure, enhance the aggregate demand or AD when the inflation rate is below the expected levels. 

In this situ, the relevant policy action is to reduce the interest rate and expand the credit levels so that all interest sensitive expenses in the economy, namely consumption and investment, will be higher than the normal. In the opposite case, the bank will curtail money supply and depress AD if the inflation rate is above the expected levels. The relevant policy measures are the opposite, that is, increasing interest rates and curtailing credit levels. In this way, the central bank will maintain price stability enabling the public to make their economic decisions considering the long run rather than the immediate future. 

This has been the case with the old Central Bank of Sri Lanka which had been setup under the now repealed Monetary Law Act or MLA. In the new Central Bank Act, we noted that this has been formalised by requiring the Central Bank to pursue an inflation target agreed with the Government. To attain that goal, the Central Bank has been granted independence from the Government formally.

We will continue our discussion from that point.

No to monetary financing

The new Central Bank Act, abbreviated as CBA, has incorporated this philosophy of central banking to its core provisions. The invisible hand of the Minister of Finance over the monetary policy making by the Central Bank has been removed by not making the Secretary to the Ministry of Finance a member of the Governing Board (section 8(2)) or the Monetary Policy Board (section 12). Though the Minister of Finance still has a hand in recommending the seven members of the Governing Board, two experts to the Monetary Policy Board and appointing the two Deputy Governors (section 15(8)(a)), they are not direct employees working under him like the Secretary to the Ministry of Finance. Hence, his influence over them is presumed to be diluted. 

Even if the Minister of Finance tries to use his invisible hand in directing the policy actions of the Central Bank, the stature of the people who are appointed to these high posts should prevent him from doing so. The Secretary to the Ministry of Finance still has a role to play in the new Central Bank by being a member of the Coordination Council of the Central Bank in terms of section 83 of CBA. But the job of that council is to coordinate the work between the Ministry of Finance and the Central Bank and not to direct the bank’s policy.

Economic revival necessitates high saving and investment. Therefore, the Central Bank can facilitate economic revival by maintaining low inflation expectations in the system and thereby creating the conditions conducive for people to save and invest more. Sri Lanka’s rapid disinflation process from September 2022 and de-inflation in the fourth quarter of 2024, inflation expectations have been significantly lower. This is the best the new Central Bank can give to the economy which is struggling to revitalise itself and attain recovery and growth 

Section 5 of CBA has spelt out that the Central Bank should have financial and administrative autonomy, and it is accountable for it. A missing feature in this autonomy is the absence of policy autonomy which is not covered by the financial autonomy spelt out in the Act. The central bank credit is generated by creating new money and therefore, it is known as ‘monetary financing’. Section 86 of CBA has prohibited the Central Bank to offer such monetary financing, directly or indirectly, to the Government or any public authority owned by the Government or any other public entity, except State banks for which the bank may lend to overcome their liquidity problems.

This is a major departure from the repealed MLA under which the Central Bank could grant monetary financing by buying Treasury bills from the primary market and accommodate Government’s liquidity problems through an overdraft facility known as ‘provisional advances’. What this means is that the Government cannot fill its budget deficit by borrowing from the Central Bank and any development initiative of the Government should be undertaken without the monetary financing support of the Central Bank. The Central Bank cannot provide loans to commercial banks too under CBA by resorting to monetary financing. Hence, in the new scenario, the Central Bank’s support for economic recovery and growth should not be through money creation but through other means.

Flexible inflation targeting

These other means are the maintenance of price stability, stability of the financial system, and through them, taming public’s high inflation expectations and building confidence of the public in the smooth operation of the financial system. The first requirement is achieved by the Central Bank by following the provisions of Part IV of CBA which stipulates that the Central Bank should sign a ‘monetary policy framework agreement’ with the Minister of Finance agreeing on the inflation target to be achieved by the Central Bank (section 26). 

If there is a disagreement between the Minister of Finance and the Central Bank about the appropriate inflation target, the provision been made in CBA for the Cabinet of Ministers to function as the arbitrator and set the inflation target for the country. When invoking these special provisions, a problem will arise if the Cabinet sets an inflation target higher than what the Central Bank wants to maintain because it amounts to inflating the economy through reckless money printing.

Though the statutory provisions are only for inflation targeting (IT), the Central Bank has announced what it follows is flexible inflation targeting (FIT) moving away from the legal mandate given to it by Parliament2. By adding this ‘flexible’ feature to IT, the Central Bank has arrogated to itself a space for changing IT, by way of relaxation or tightening the set target, to accommodate the special conditions that might emerge in the economy. The strict inflation targeting seeks to stabilise only the inflation with no regard to what happens in the real economy3. This is a difficult job because there is a time lag in monetary policy action, transmission of same to the financial sector, and exertion of its impact on the real sector activities.

For instance, the Central Bank may notice that inflation has risen. It takes time for the bank to increase its policy interest rate to tackle it. Policy interest rate being the extraordinary marginal costs of commercial banks, its increase will have an impact of the actual marginal costs of commercial banks, namely, interbank call money rates (IBCM). Then, it will take further time for banks to revise their deposit and lending rates. While big businesses may notice it immediately and adjust their real sector investments accordingly, for a micro, small, and medium enterprise (MSME), it takes a long period to make the required real investment adjustments. Since the objective is to stabilise both prices and the real economy, attaining both simultaneously is a difficult task requiring accurate inflation and real growth forecasts.

However, this flexible inflation targeting is synonymous with the economic and price stability objective of the repealed MLA. When pursuing the economic and price stability, the Central Bank should watch over the developments in other nominal sectors in the economy like the exchange rate, budget balance, and public debt situations in addition to the real economic performance. A similar watchful behaviour is needed on the part of the Central Bank when pursuing FIT too. In the absence of reliable economic forecast data, it is the wisdom involved in a rule of thumb monetary policy that is required to gain success by the Central Bank.

Even if the Minister of Finance tries to use his invisible hand in directing the policy actions of the Central Bank, the stature of the people who are appointed to these high posts should prevent him from doing so. The Secretary to the Ministry of Finance still has a role to play in the new Central Bank by being a member of the Coordination Council of the Central Bank in terms of section 83 of CBA. But the job of that council is to coordinate the work between the Ministry of Finance and the Central Bank and not to direct the bank’s policy

Overnight policy rate

Further, in FIT, the Central Bank is controlling its policy interest rate to attain success. The Central Bank of Sri Lanka has introduced a single policy interest rate, called Overnight Policy Rate (OPR) linked to the weighted average of the interbank call money rate (AWCMR)4. Due to structural bottlenecks, interbank call money rate is not a market determined rate. This further complicates the Central Bank’s attempt at gaining success in conducting monetary policy through FIT5.

Monetary policy framework agreement

The first monetary policy framework agreement by the new Central Bank was signed with the Minister of Finance on 5 October 20236. This agreement which has come into effect from the date of signing has stipulated that it is the quarterly average of the headline inflation measured through the compilation of the Colombo Consumers’ Price Index (CCPI) by the Department of Census and Statistics that is targeted for Sri Lanka. The agreement is that the Central Bank should maintain the quarterly average of CCPI at 5% per annum with provisions for going up to 7% or moving down to 3%. 

Accordingly, the Central Bank has full freedom to adopt monetary policies to keep the inflation within this corridor independent of any other interested parties, government, businesses, households, or international organisations. If it fails, then, it is accountable to the public and make suitable clarifications why it has failed and what action it will take to remedy the situation. In the fourth quarter of 2024 in which the quarterly average of the headline CCPI has fallen to the negative region and if it continues in the next quarter too, such a clarification is warranted from the central bank.

Lowering inflation expectations

When a country has experienced low inflation for some time and when the public has confidence about the independence of the central bank, the inflation expectations too tend to be lower. It is the inflation expectations, and not the actual inflation, that matter because it is the inflation expectations that influence public’s behaviour relating to consumption, savings, and investment7. When expectations are high, people tend to consume more in the current period, and, hence, save and invest less, and incorporate those high expectations to medium to long-term contracts they sign.

The opposite takes place when inflation expectations are low. Economic revival necessitates high saving and investment. Therefore, the Central Bank can facilitate economic revival by maintaining low inflation expectations in the system and thereby creating the conditions conducive for people to save and invest more. Sri Lanka’s rapid disinflation process from September 2022 and de-inflation in the fourth quarter of 2024, inflation expectations have been significantly lower8. This is the best the new Central Bank can give to the economy which is struggling to revitalise itself and attain recovery and growth.

When pursuing the economic and price stability, the Central Bank should watch over the developments in other nominal sectors in the economy like the exchange rate, budget balance, and public debt situations in addition to the real economic performance. A similar watchful behaviour is needed on the part of the Central Bank when pursuing FIT too. In the absence of reliable economic forecast data, it is the wisdom involved in a rule of thumb monetary policy that is required to gain success by the Central Bank

Job of the real sector participants

Since the Central Bank has done its job, the real sector development should come from the real sector participants, namely, households, businesses, and the Government. All these entities should reckon low inflation scenario and allocate resources immediately, in the short to medium run and in the long run to promote the production of real sector goods and services. This was clearly laid out by John Exter in his first press interview after assuming office on 28 August 1950. Exter said: “There is no financial wizardry by which the bank can suddenly pull out a hat of a higher standard of living for everybody. The bank’s contributions must necessarily be a long run contribution. The bank does not itself produce goods and services, but it should by creating the right monetary conditions, enable the country” to do so9.

It seems that the philosophy of central banking has not changed from Exter Report to new CBA.

 Though the statutory provisions are only for inflation targeting (IT), the Central Bank has announced what it follows is flexible inflation targeting (FIT) moving away from the legal mandate given to it by Parliament. By adding this ‘flexible’ feature to IT, the Central Bank has arrogated to itself a space for changing IT, by way of relaxation or tightening the set target, to accommodate the special conditions that might emerge in the economy. The strict inflation targeting seeks to stabilise only the inflation with no regard to what happens in the real economy. This is a difficult job because there is a time lag in monetary policy action, transmission of same to the financial sector, and exertion of its impact on the real sector activities

Footnotes:

1https://www.ft.lk/columns/Economic-development-role-of-Central-Bank-under-new-Central-Bank-Act-Part-I/4-777736

2https://www.cbsl.gov.lk/en/monetary-policy/about-monetary-policy

3Svensson, Lars E.O, 2009, Flexible inflation targeting: Lessons from financial crisis, available at: https://www.bis.org/review/r090923d.pdf

4https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/press/pr/press_20241126_the_cbsl_implements_a_single%20_policy_interest_rate_mechanism_ny_introducing_the_opr_e.pdf

5For the operation of OPR, see Wijewardena, W.A, 2024, “Child’s Guide to Central Bank’s new monetary policy instrument: Overnight Policy Rate”, available at: 6https://www.ft.lk/columns/Child-s-guide-to-Central-Bank-s-new-monetary-policy-instrument-Overnight-Policy-Rate/4-769937

7http://documents.gov.lk/files/egz/2023/10/2352-20_E.pdf

https://www.clevelandfed.org/publications/ask-the-expert/2019/ate-20190528-rich

8See the statement by Governor Nandalal Weerasinghe before the Organization of Professional Associations in August 2024 at https://www.clevelandfed.org/publications/ask-the-expert/2019/ate-20190528-rich

9Quoted by Wijewardena, 2017, Central banking: Challenges and Prospects, p 20.

Concluded

Part I can be seen at https://www.ft.lk/columns/Economic-development-role-of-Central-Bank-under-new-Central-Bank-Act--Part-I/4-777736

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)