The monetary policy is largely about regulating money, credit, interest rates and exchange rates to facilitate the growth and stability of the economy, income, employment and living standards of people. Central banks are mandated for the monetary policy among several other duties such as supervision of banks and financial institutions and the agent of the government for some tasks. The policy mix is highly intellectual and incoming data-driven with diverse explanations. Therefore, what is necessary is the delivery of policy promises consistently.
Present Monetary Policy Model
* Inflation Control
Following the policy frameworks of the US Federal Reserve (Fed) and western central banks, many central banks in the past two decades have been practicing the monetary policy for controlling inflation at some targets by printing money to keep overnight inter-bank interest rates within certain targets as determined by them. Such interest rate targets are the policy rates at which central banks lend money to and accept deposits from commercial banks overnight. The money printing is largely the lending to banks in deficit net of absorbing money from banks in surplus.
Central banks believe that this type of money printing will drive the economy towards the target of inflation that they believe desirable for undefined macroeconomic stability in the unknown medium to long term.
* Policy Interest Rates
The single most monetary policy action/decision is the change in policy interest rates. Other monetary policy instruments are used under-cover from time to time. Policy interest rates are changed in small amounts (0.25% to 0.50) in cycles, i.e., period of raising in several years (policy tightening) followed by reducing in several years (policy relaxing). The length of the cycle, level of interest rates, target of inflation and monetary policy governance vary across the countries.
However, no central bank has any empirical research to establish that they are able to control inflation at targets, despite confused communications in technical jargon.
In the past, central banks have followed different approaches of monetary policy, i.e., targets of exchange rate and monetary growth, with different policy instruments.
Fed’s Monetary Policy That Runs Global Economy
* Policy Tightening Cycle
The US Fed followed an ultra-relaxed monetary policy around zero interest rates (0-0.25%) and excessive money printing during 2007-14 to recover from the global financial crisis 2007/09. Then, it started tightening the policy since December 2014. The tightening was accelerated since December 2016 to December 2018 by raising interest rates in eight times by 2% from 0.25%-0.50% to 2.25%-2.50% and reducing/tapering its balance sheet by about US$ 480 bn in 2018 to absorb money permanently from the economy. In December 2018, the Fed speculated another three interest rate hikes (by 0.75%) in 2019.
* Adverse Consequences
The intellectual justification for such fast tightening was to move towards neutral interest rates (around 3.00-3.25%) at the time the economy was strong, with a view to control inflation symmetrically around the target of 2% in future. However, this monetary policy destabilized both the US and world economy due to capital outflows to the US and sharp appreciation of the US Dollar being the major global reserve currency.
In response, many central banks raised domestic interest rates to compete for foreign capital. Market analysts led by the US President Donald Trump started heavily criticizing the Fed for policy tightening labelled as quantitative tightening. A former Fed Chairman Ben Bernanke commented that the US economy would start confronting a recession since 2020.
* Policy Pause on March 20, 2019
The US economy now confronts some slower growth and employment generation than in 2018 and failure to secure inflation symmetrically around 2% target. Therefore, the Fed/FOMC at the last meeting held on March 20, 2019 decided to pull-back from the monetary tightening. For first time, it announced the monetary policy goal as sustaining economic expansion along with its statutory goals of maximum employment and stable prices. The Fed stated that it did not have data to support any of raising or cutting interest rates. This is a policy U turn.
Accordingly, the Fed kept interest rates unchanged. The dot plot of the FOMC members (individual forecasts of interest rate hikes) showed no interest rate hikes in 2019 by 11 members and one-time hike by 4 members. Second, it decided to slow down the tapering of Fed balance sheet and paused tapering since September 2019.
In response, central banks of several emerging market economies who raised interest rates competitively in the second half of 2018 also decided to keep them unchanged.
Monetary Policy of UK, EU and Japan
All three are still following ultra-relaxed monetary policy since late 2007 to recover from the global financial crisis. Although they had expressed the possibility to commence tightening in 2019, they now have communicated the continuation of the relaxed policy throughout 2019. Growth and inflation not rising to targeted levels, slower global growth and trade disputes are the major factors. Policy interest rates of EU, Japan and Sweden are still negative rates (e.g., commercial banks pay interest to the central bank for keeping their deposits).
In this background, no major monetary policy changes are expected in 2019 in advanced market economies. Therefore, other central banks have the greater freedom to maneuver their policies for domestic purposes.
In this background, the Monetary Board (MB) on April 8, 2019 couldstart acting aggressively to fix pressing macroeconomic problems, but just decided to keep policy interest rates unchanged complacently.
Sri Lankan Monetary and Economic Slump
* Monetary Slum
The monetary slump is shown between March 2018 and February 2019 by considerable decline of growth of reserve money (printing of money) from 11.8% to 2.7%, money supply from 16.4% to 11.4% and net foreign assets of the banking system from 126.8% to negative 189.2%. This is the direct result of foreign capital outflow and resulting currency depreciation since September 2018 as shown by the decline of net foreign assets of the banking system to negative Rs. 103 bn (foreign liabilities greater than foreign assets) in February 2019 from Rs. 106 bn in March 2018.
This shows an outflow of foreign capital of nearly Rs. Rs. 209 bn. which caused the erosion of liquidity/money from the banking sector. As a result, the gross official reserve declined to US$ 6.2 bn by end of January 2019 (improved to US$ 7.6 bn by end of March 2019 due to sovereign bond receipts) from US$ 9.3 bn as at end of June 2018, despite the CB’s brave talks of foreign currency stabilization and projected foreign reserve around US$ 11.3 bn.
* Economic Slump
The monetary slump augmented the economic slump. The economic slump is shown by the fall of economic growth from 5% in 2015 to 3.2% in 2018 against the target of 5% and fall of inflation (CB’s favourite NCPI) to 1.2% in January 2019 from 5.4% in January 2018 way below the MB’s inflation target of 4%-6%. The slump remained in February too at 2.4%.
Therefore, the MB has failed to maintain economic and price stability of the country at own targets.
* Recent Monetary Policy Actions
The MB has been using a mix of monetary policy measures covering excessive money printing to fund money dealers and government to control interest rates, increase of standing deposit facility rate by 0.75% and standing lending facility rate by 0.50% (i.e., policy rates corridor of 8% and 9%), reduction of statutory reserve ratio by 2.5% from 7.5% to 5% and few import credit controls (200% LC margin on vehicle imports, 100% LC margin on selected non-essential imports and loan-to-value ratio vehicle financing).
* Government Working Group
The media reported that the government has appointed a working group consisting of a MB member to make recommendations on monetary policy solutions. This shows the inability of the MB to implement the monetary policy in the greatest advantage of people and the loss of independence of the MB. Under section 116(2) of the MLA, the Minister of Finance has the authority to direct the MB to adopt the government policy while the government accepting the responsibility. It was reported that the MB has accepted the working group recommendations.
The working group has mixed up the subject by covering topics such as accounting standards and bank capital requirements which are unrelated to monetary policy but have prudential and consumer protection aspects that should be handled separately.
Monetary Policy Communications
* Blame Fiscal Front
The MB makes many hypothetical statements without research and often criticizes fiscal policy/government. In January press release, the MB noted the reliance of the government and weak state enterprises on domestic sources of credit, which is not new. In last press release too, the MB again noted the need for implementing growth enhancing structural reforms expeditiously. The MB is also responsible for it and should stipulate what those reforms are. In general, the MB always finds the fiscal front as the scapegoat.
The Fed Chairman at the last news conference on March 20, 2019 stated that “we take fiscal policy as exogenous to what we do. Whatever happens to fiscal policy we take that. We don’t evaluate it. We don’t criticize it. We don’t overreact to it either. It is just an external fact about the economy for us”.
* Ad-hoc Data-Dependence
Most economic information given in the press releases is ad-hoc/interim developments on credit, foreign exchange, prices and growth. The current appreciation of the Rupee is not due to improved BOP of the country or foreign reserve, but is an interim result of new cross currency rates arising from global market response to the US monetary policy pause. The Rupee depreciation is still about 14.5% from the level of end of 2017.
The monetary policy must be assessed on the basis of trends of leading macroeconomic indicators and not on such ad-hoc developments because the monetary policy is to ensure the stability of the economy over the trend of many years.
The public do not get any opening statement of the Governor and subsequent questions and answers in official scrips. Therefore, the public have to depend on what the media report as they understand. This prevents public discussion on the monetary policy appropriate for the country.
(The next article will be on appropriateness of present policy mix)
(The writer is a former Deputy Governor of the CB and chairman and member of 6 Public Boards with nearly 35 years of public service. He authored 6 economics and financial/banking books and more than 60 published articles.). His latest Book is “INNOVATING CENTRAL BANKS” just released.
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