Money printing, inflation and inflation targeting

During the recent months, there have been several newspaper articles, web postings and discussions in electronic media, on the causality of excessive money printing and inflation which, had been originated by a “leading economist” Dr. Harsha de Silva. Considering the potential damage that may be caused by a constant build up of such erroneous and misleading analysis, which could, in turn, lead to permanent misperceptions, we provide an explanation on the fundamentals, processes, and the reality of money printing by the Central Bank for the benefit of the general public.

The technical analysis, sound logic, and professionalism of our paper has been understood and accepted by academics, experts and the general public on the grounds of scientific approach, clarity and integrity. The explanatory article has also been circulated among international investors and our counterpart research economists around the world and it has received several commendable responses. Moreover, the article has been accepted by one of the national universities in Sri Lanka to be published in their annual economic journal as well. Hence, our effort has had the desired result and we are satisfied with the outcome.

However, this “leading economist” is continuing his mission of hurling innuendo and spurious theories, while being unable to challenge the arguments, logic and the technical content of our article. As is customary, a large part of his most recent article is allocated to personally attack Ajith Nivard Cabraal, the Governor, of the Central Bank. Thereafter, he attacks Dr. Nandalal Weerasinghe, Director Economic Research, as well as the author of the article whom he casually attempts to discount as a ‘junior officer’.

The rest of his response is based on a few highly inconsistent arguments and blatantly erroneous technical analysis. It is very unfortunate that this “leading economist” as he introduces himself, has failed to understand the basic technical arguments presented by a ‘junior officer’, and is still persisting with his own new-found theory of a relationship between Treasury bill holdings of the Central Bank and inflation.

During the past few months, the Governor of the Central Bank made a series of presentations to diplomats, government officials, professionals, investors and foreign and local media on the theme: “Sri Lankan Economy: Perceptions and Claims vs. Realities”.

This presentation addressed various misperceptions about the country’s economy and provided a detailed and realistic position on various economic issues. As stated upfront in the presentation, one of the intentions of such presentation was to dispel the predictions of gloom and doom about the economy that has been made by some political personages under the guise of economic experts. In that regard, the Governor’s presentation referred to “terrorist sympathizers” and others who are “deliberately targeting the Sri Lankan economy” in the promotion of their own dubious agendas. It also referred to persons who have “deliberately attempted to undermine the economy by making threats of non-repayment of sovereign debt”. The Governor, however, did not mention any specific personality, as being the person or persons who are behind this campaign of spreading myths and misperceptions. In that context, if a particular leading economist is of the view that the behaviour referred to in the presentation applies to him that perhaps would be a case of “putting on the cap because it fits”.

Dr. Silva has apparently been deeply hurt with Dr. Nandalal Weerasinghe’s presentation at the Accounting Forum organized by the Accountancy Department of University of Kelaniya and therefore has decided to embark upon a vituperative attack against Dr. Weerasinghe as well. In his presentation, Dr. Weerasinghe has clearly elaborated the concepts of inflation and the contemporary issues, and the distinguished audience comprising of professors, lecturers, and students of the University of Kelaniya, had readily understood and appreciated this presentation, judging by the response he received at, as well as, after the presentation.

Relationship between Net Credit to the Government and Inflation

Over the past several months, Dr. Silva had been repeatedly presenting a graph titled “Printflation” that shows a relationship between the Treasury bill holdings of the Central Bank, (which he considers as “money printing”) and inflation. Very interestingly, in his latest article, he seems to have abandoned his favourite graph. The fact that he has not referred to such graph in his latest article may hopefully signal that he has finally understood the folly of his logic. But, now he presents a new graph on the same lines, without the Treasury bill holdings of the Central Bank, but replacing such figures with the Net Credit to the Government (NCG), and comparing it with inflation. We have already pointed out that any increase in NCG is only a part of “new money” and the relationship (without lags) between NCG and inflation is spurious. We have also pointed out the fundamental principle that one cannot compare incompatible variables, and that if he is professional he may compare the changes in NCG with the changes in prices levels with certain time lags. Dr. Silva has apparently taken that advice, and the graph in his latest article confirms his admittance, as he has now dropped “year-on-year inflation” from it. However, he very conveniently limits the time period of the comparison only up to July 2007, despite data being available for 2008 as well. (Dr. Silva had used data up to January 2008 in his previous article!).

As we have pointed out in our previous article, a certain relationship would exist between the change in NCG and the changes in prices levels with a time lag, since NCG is a component of money; however, the relationship is not a simple one. Any attempt to explain movements in inflation using a simple two-variable regression model, with or without time lags, is a very primitive, amateurish and outdated approach. Money, NCG, and private sector credit are useful and leading indicators of demand driven inflation, but do not fully explain headline inflation. This is the reason why many central banks and monetary economists around the world have developed several sophisticated inflation forecasting models taking many other factors into consideration, as well.

Zero Inflation or Deflation in 2008, according to the de Silva theory

The Central Bank has control over “Reserve money”, and hence puts its best efforts to control the reserve money in order to achieve the final objective of price stability. Such actions are clearly based on the fundamental link between monetary aggregates and inflation. Hence, there should be no controversy about that premise. However, the moot point is that, although Dr. Silva admits that he believes that there is relationship between money and inflation, and also NCG and inflation, he inexplicably or perhaps deliberately (because it does not suit his argument) rejects and/or disregards the relationship between reserve money and inflation.

Let us now examine the validity of Dr. Silva’s first theory: (the so called one-on-one relationship between NCG and inflation) against the actual situation that exists today. If his profound theory is true, Dr. Silva will be overjoyed to note that the Treasury bill holdings of the Central Bank was nearing zero levels in March due to the sterilization of large foreign currency inflows by the Central Bank. According to Dr. Silva, inflation should therefore now reduce to zero or we should be experiencing deflation! Let us also examine Dr. Silva’s revised hypothesis: i.e. that the growth in NCG causes inflation with a time lag. This time round, he has been a little careful not to reveal the length of lag. Nevertheless, here too, according to Dr. Silva’s theory, inflation should come down substantially in the next few months and reach zero level! Or, we could even have deflation after a few months! So much for these theories!

Current Inflation: Cost-push or Demand-pull?

As would be clear, an excessive expansion in monetary aggregates occurred from about 2004 to 2006, and foreseeing the threat on price stability, the Central Bank had adopted timely and precautionary policy measures. In fact, it was a policy package that was implemented, and as a result, we were able to achieve reserve money targets in 2007 and so far in 2008. Growth rates in credit to the private sector and broad money are now on decelerating trends. Excessive demand is being contained as reflected by many indicators. We have controlled money printing, and hence we have notably curtailed the demand driven component in inflation. Hence, demand management polices are clearly impacting on demand-pull inflation. However, supply side and external factors have pushed inflation beyond the expected levels and these have contributed to the surge in price levels in the economy.

Comparing Inflation across countries

A valid question for a layman to ask is as to why some countries are experiencing lower inflation, than others. In this context, eminent economists would of course be well aware that the direct comparison of inflation across countries is not that simple. First, in a technical context, the definition of the index, which includes the coverage, weights and the nature of the basket, will be different across countries.

Second, in an economic context, the size, openness, subsidy packages, relative price levels and productivity levels in different countries will have an asymmetric impact on inflation. Third, the impact of external shocks felt by countries could be quite different, even based on the same conditions. For example, the impact of external shocks is relatively lower in countries with large domestic economies such as USA, EU, India and China whereas it is higher in small, open economies like Sri Lanka. Therefore, any scientific analysis of headline inflation figures across countries should be done with caution, while considering other structural and technical differences in those countries, as well.

Even in a single country, different price indices based on different weights, baskets and geographical locations give different inflation numbers. For example, inflation figures measured by SLCPI, CCPI and CCPI (N) are different. In India, while the overall inflation remains around 5 per cent, it ranges from 1 per cent to 15 per cent in different cities across the country. Due to the same reason, if hypothetically Sri Lanka was to adopt a currency board system, or fully dollarise the economy, Sri Lanka will not have the same US inflation rate as some may believe! This is simply because the average income level and the consumption pattern in the two countries are entirely different. The magnitude of the increase in inflation also needs to be considered, in any technical discourse on comparison across countries, i.e., the relative increase may also be considered in order to understand the clear picture of movement in inflation across countries.

As is well known, many countries have been hit by the unprecedented oil shock and a phenomenal increase in international commodity prices. These increases have resulted in the global food price index published by the Food and Agriculture Organization (FAO) recording a 54 per cent increase over the past year. Consequently, many countries are now facing their highest recorded inflation figures in recent times, despite the tight monetary policy stances. For example, China’s inflation in January 2008 was at its highest in 11 years. In Singapore, it was their highest in 25 years. Australia recorded their highest core inflation in 16 years. Eurozone inflation surged to 16-year high in March 2008.

It is also obvious that many countries have been acutely affected in different ways by increased commodity prices, particularly oil and food prices. For example, in January 2008, inflation in UK was 2.2 per cent whereas its food inflation was 6.1 per cent. In China, inflation was 7.1 per cent, but food inflation was 18.2 per cent. In Pakistan and Vietnam inflation was 12 per cent and 14 per cent respectively, while food inflation was 18 per cent and 22 per cent, respectively. Therefore, it would be very clear that countries have been recently experiencing high levels of inflation due to the phenomenal supply shocks and only the ignorant would believe that monetary expansion is the “only” cause.

There is strong evidence of a relationship between world food prices and Sri Lankan inflation. Our inflation is still largely driven by food inflation and therefore it should be clear that the monetary policy of the Central Bank of Sri Lanka alone cannot bring down Sri Lanka’s inflation.

Suggestion re. Adjusting Reserve Money target in response to demand for Foreign Exchange

It appears that now Dr. Silva has realized that the Central Bank releases money not merely by purchasing Treasury bills, but acquiring both domestic and foreign assets. Hence, instead of following his former argument, he now creates arguments for a further downward revision in the reserve money which had already been set too tight. If his suggestion is accepted, the bank should reduce the reserve money target in line with the decline in growth rate and following an intervention in the foreign exchange market without neutralizing its impact on rupee liquidity.

The Central Bank has a mandate to maintain economic and price stability and a further downward revision in reserve money, in response to a slowing down in growth would have accelerated the process of economic slowing down while aggravating the inflationary pressure arising from supply side factors. As clearly stated, the Central Bank’s policy in the foreign exchange market is to intervene to remove unwarranted excessive volatility arising from unfounded perceptions and speculative movements and not to change the underlying trend in the exchange rate. Monetary policy decisions are based on underlying trends in key macro variables, which have been taken into account in setting monetary targets. The intervention to remove volatility in the exchange rate needs to be sterilized as it is not a reflection of a change in underlying trend and hence “real demand for money” as otherwise there would have been more volatility in financial markets. Since the beginning of this year, the Central Bank has purchased a large amount of foreign exchange in the domestic foreign exchange market to build up reserves and prevent an undue appreciation in the exchange rate and thereby injected a large volume of rupee liquidity into the market. If the Bank were to follow Dr. Silva’s advice, the trend toward appreciation is an increase in the “real demand for money” and hence, the increased rupee liquidity should not be sterilized, but the reserve money target should be revised upwards. One could imagine the implications of such action particularly at a time when there is relatively high inflation.

Inflation targeting

Over the years, Sri Lanka’s monetary targeting framework has been gradually developed in line with global developments in monetary policy and macroeconomic management with an intention to move to an inflation targeting framework. Over the years, the Central Bank has been modifying the monetary targeting framework to facilitate moving into an inflation targeting regime. A widespread discussion on adopting inflation targeting in countries started at least a decade ago and Sri Lanka too has been involved closely with such discussions.

Over the years, we have been researching and examining the feasibility of adopting inflation targeting in Sri Lanka and several initiatives have already been undertaken.

Long before Dr. Silva’s recent kind advice, we have been in consultation with respected leading economists of our country about the feasibility and possible timing of such a framework. In fact, the possibility of moving towards such a framework in the medium term was stated in our Road Map 2008, enunciated by the Governor on January 2, 2008 and in the Strategic Plan of the Central Bank.

Such actions clearly indicate that we are in the process of fulfilling the prerequisites in a professional manner so that we will be able to adopt a country specific and full-fledged inflation targeting framework in the medium term.

Moving to an inflation targeting framework from monetary targeting framework is a process and not a simple “switching” operation as suggested by Dr. Silva.