Rising money supply pushes inflation into double digits

The government has obtained as much as Rs. 1,658 billion in net credits from the Central Bank and commercial banks in the past 12 months. This reflects the extent to which liquidity is injected into the market through bank loans to the government.

The annual inflation rate hit double digits for the first time after a 12-year hiatus, exacerbating Sri Lanka’s multi-faceted economic crisis. The economy is already plagued by external debt servicing problems, low remittances and tourism receipts, a shortage of foreign exchange, shortages of consumer goods, low savings and investments, and declining production. .

While supply shortages, high production costs, the depreciation of the rupee, and rising import prices have had cost push effects on inflation, the profound impact of demand pull resulting from the rapid growth of the money supply on inflation cannot be underestimated. Money supply has grown by 42% over the past two years, from Rs. 7,456 billion in October 2019 to Rs. 10,582 billion in October 2021.

The accommodative monetary policy adopted by the central bank authorities following the obscure modern monetary theory (MMT) since the beginning of last year is the most important factor which has led to the unprecedented increase in mass monetary policy and, consequently, high inflation.

Contrary to the position maintained by the central bank authorities on the neutral effect of money supply growth on inflation, the looming inflationary pressures on the horizon were projected in this column several months ago (https : //www.ft.lk/columns / Pressions-inflationnistes-al-horizon / 4-712891).

Growth of the money supply

Broad money supply (M2), defined as the narrow money supply (currencies and demand deposits) plus term and savings deposits held by the public with commercial banks, has increased by 17% over the past 12 years. month. This was due to a 23% increase in net domestic assets of the banking system mainly caused by the rise in net credit to government (NCG).

The increase in the money supply was largely the result of the 38% increase in the NCG; CNG disbursed by the Central Bank and commercial banks increased by 156% and 15% respectively.

The government has obtained as much as Rs. 1,658 billion in net credits from the Central Bank and commercial banks in the past 12 months. This reflects the extent to which liquidity is injected into the market through bank loans to the government.

The central bank loses control of the money supply

As stipulated in the Monetary Law Act, the Central Bank is directly responsible for maintaining price stability, which is a prerequisite for macroeconomic economic stability. The policy instruments available to the Central Bank for this purpose include open market operations (OMOs, i.e. the buying and selling of treasury bills and bonds), interest rates. policy interest, statutory reserve ratio (SRR), officially announced exchange rate and foreign exchange transactions.

As the Central Bank continues to lend to the Treasury to finance its cash deficits as noted above, monetary policy is severely constrained by budget deficits reflecting fiscal dominance over monetary policy. As a result, the Central Bank is unable to mop up excess liquidity through the OMO by selling treasury bills in the market. This resulted in a sharp increase in the monetary base and in the issuance of currencies (banknotes and coins) causing an increase in the money supply. The central bank has also been cautious in making upward adjustments in key interest rates to contain market liquidity due to the implications of interest rate hikes on the debt liability.

Regarding the exchange rate also, the Central Bank chose to maintain an unrealistic fixed exchange rate to avoid possible negative effects of the depreciation of the rupee on inflation and external debt liabilities.

Thus, the central bank lost its grip on its main policy instruments – interest rates and exchange rates. Without these two policy instruments, an open economy cannot endure, as articulated by the well-proven Mundell-Fleming model.

Impact of money supply on inflation undeniable

Central bank authorities have refused to accept the well-established relationship between money supply and inflation which is based on monetarism founded by world-renowned economist Milton Friedman.

Contrary to what monetary authorities think, there is a close relationship between money supply growth and inflation in Sri Lanka, as the graph shows. Year-on-year inflation, as measured by the Colombo Consumer Price Index (ICPC) hit 9.9% in November 2021, nearly hitting double-digit for the first time since 2009.

The sharp increase in the money supply has resulted in an increase in market liquidity relative to slow GDP growth. This has led to the situation economists describe as “too much money for too little good”. Contrary to traditional economics, the central bank authorities are unwilling to accept this cardinal principle.

The inflationary pressures of the money supply clearly reflect the pitfalls of the so-called modern monetary theory adopted by the Central Bank since the beginning of last year to meet the budgetary needs of the government by directly purchasing government bonds and bonds. Treasury, as I argued in a previous FT column (http://www.ft.lk/columns/Money-printing-to-repay-Govt-debt-worshipping-MMT-is-likely-to-magnify-economic- instability / 4-710612).

Inflation targeting monetary policy

Since the 1980s, the Central Bank has pursued a monetary policy with a targeted monetary aggregate. Overall, monetary targeting has proved problematic due to the instability between monetary aggregates and target variables such as inflation. Thus, monetary targeting frameworks have been minimized or abandoned in several countries.

A number of monetary authorities around the world have started using inflation targeting for the conduct of monetary policy following the success in New Zealand which initiated inflation targeting in 1990. In terms of As a policy framework, the central bank takes responsibility for maintaining a pre-announced inflation target using a monetary policy tool such as the interest rate. In this case, the central bank concerned is fully responsible for keeping inflation within target. The success of inflation targeting, however, depends on several factors, including fiscal discipline aimed at a low budget deficit.

In Sri Lanka, initiatives were taken four years ago to introduce the inflation-targeting monetary policy framework under the Extended Financing Facility (EFF) with the IMF during the period 2016-2019 . According to, the Central Bank was to engage in a monetary policy framework with an inflation target of 4-6% envisaging a fall in the budget deficit to 3.5% of GDP by 2020. However, this does not happen. never materialized, because the current government abandoned the EFF at the end of 2019.

Such an inflation-targeting monetary policy framework could have strengthened the ability of the central bank to conduct monetary policy prudently by freeing itself from political pressures to meet fiscal needs.

Arguments against unfounded inflation targeting

India adopted an inflation targeting regime in 2016 as part of a new monetary policy framework. Arguing against such a policy, Surjit S. Bhalla, IMF executive director who represents India, Sri Lanka, Bangladesh and Bhutan says inflation targeting in India has contributed to lower GDP growth. rather than containing inflation (https: / /indianexpress.com/article/opinion/columns/inflation-rbi-monetary-policy-indian-economy-7236363).

He says, “Countries that have not adopted inflation targeting show lower inflation than those that have. Inflation targeting also has costs in India. This has led to higher real policy rates, mistakenly thinking that high policy rates affect the price of food, oil or anything else. But high real rates affect economic growth, by affecting the cost of domestic capital in this ultra-competitive world ”.

He further claims that the decline in inflation rates around the world over the past two decades due to globalization, demographics and the unlimited supply of skilled labor has coincided with the introduction of central bank inflation targeting regimes. Therefore, the decline in inflation cannot be attributed to inflation targeting, according to Bhalla. He concludes with the remark “current reality of no country for inflation targeting”.

Bhalla’s pessimistic view of inflation targeting is misleading, as his study does not have a solid theoretical or empirical basis. Its findings are based exclusively on simplistic comparisons of median inflation targeting inflation rates versus non-inflation targeting regimes in emerging markets and advanced economies over the period 1990-2019.

The conclusions of Bhalla’s study are not supported by any robust econometric tool such as the Granger causality test to determine the impact of inflation targeting on the general price level of each country using the relevant macroeconomic variables. , including the budget deficit, money supply and central bank loans to the government. .

Therefore, Bhalla’s conclusion, “There is very little evidence – to India or the rest of the world – that inflation targeting works or has worked” is unacceptable.

Independent central bank with inflation targeting needed for Sri Lanka

It is recognized around the world that the more independent central banks are more successful in achieving their primary objective – price stability. The reason is that central banks which are under the direct influence of the government, as in the case of Sri Lanka, are forced to fill the unfunded portion of the budget deficit using their discretionary monopoly power to create “money.” fiduciary ”to lend to the government.

Government revenue generation through such money creation, known as “seigniorage”, increases the monetary base of the central bank, resulting in multiple expansion of the aggregate money supply causing inflation. This is exactly what has happened in Sri Lanka since last year due to misguided monetary policy formulation which has led to double digit inflation accelerating.

In order to insulate monetary management from these inflation-biased political pressures, the independence of the central bank becomes crucial. Like the initiatives taken in Sri Lanka a few years ago to design an independent monetary authority through the now-abandoned Central Bank bill as well as strict fiscal discipline, a prudent monetary policy aimed at targeting inflation seems a reality. distant.

(The author is Emeritus Professor of Economics at the Open University of Sri Lanka and a former central banker, contactable at [email protected])

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