Road Map 2020 and the need for “enlarging the Central Bank premises”
View(s):Governor of the Central Bank of Sri Lanka, Prof. W.D. Lakshman, on Monday, presented the Road Map 2020 highlighting the monetary and financial sector policies for the year 2020 and beyond. Given the central banking objective of maintaining economic and price stability, the banking regulator has the mandate to implement monetary policies and financial sector policies to achieve this objective.
Monetary policies are aimed at influencing interest rates and money stock (liquidity) in the economy. Financial sector policies are aimed at influencing the system stability by regulating and monitoring the financial sector. Both types of policies are ultimately to manage economic and price stability. When the prices are managed by the Central Bank avoiding inflation or deflation then it helps achieving and sustaining the country’s growth momentum. We should not forget that here is a reverse causation as well: When the country’s growth momentum is not maintained, then it would sabotage the Central Bank’s objective of managing the prices.
I thought of taking the Central Bank’s Road Map 2020 today to provide an informative discussion on the monetary policy, its direction, and challenges. We would also simplify how this monetary policy – managing interest rates and liquidity level in an appropriate manner-, leads to the price stability outcome.
Challenges from every side
As the country is moving into the third decade of the millennium, the challenges have emerged from every side. As the Road Map highlights at the outset, some of these challenges are “…below potential growth, persistence of poverty pockets, underutilisation of productive resources, inadequate expansion and diversification of exports, shortfall of non-debt creating capital inflows, large credit and interest rate cycles, and high fiscal deficits and public debt levels”.
None of the challenges has anything to do with central banking and, neither can the Central Bank do much about them. Nevertheless, by its mandate the Central Bank has to be responsive to these challenges and, has to support overcoming the challenges by its way of conducting the monetary policy. It has to stabilise inflation at manageable level, while supporting the growth momentum of the economy, because inflationary pressure can undermine the growth objective.
The inverse of the above episode has no validity either: The Central Bank can maintain the price stability as it did over the past few years, but still growth can slow down as it happened in the recent past.
As per its monetary approach to the economic and price stability – the so-called flexible inflation targeting (FIT), the Central Bank had aimed at maintaining the medium-term inflation rate at between 4 – 6 per cent. And the inflation rate was indeed within this range so that there was no inflationary pressure built up in the economy to weaken the growth momentum. But growth weakened continuously, reaching the lowest rate of growth possibly at 2.8 per cent in 2019.
Interest rate and liquidity
Interest rates and the liquidity levels are probably important determinants of the inflation rate of a country. Interest rates ultimately determine the cost of credits. At higher interest rates, credit expansion decelerates and credit-based spending slows down; at lower interest rates, credit expansion accelerates and credit-based spending increases. Liquidity level is the amount of money available in the economy, while its variation also influences credit expansion and spending. When there is excess liquidity (more money), banks are in a better position to lend more so that credit expansion accelerates and spending rises. When there is a liquidity shortage, banks have to be cautious in lending so that credit expansion declines and spending slows down.
Audience at the presentation of the Road Map.
Both the interest rates and liquidity levels influence the aggregate demand – particularly the consumer spending and business spending. The increase in aggregate demand in the absence of a corresponding increase in domestic supply exerts pressure on the prices, causing an increase in inflation. Therefore the Central Bank can use the monetary policy instruments to manage inflation rate within a target zone. When the Central Bank perceives that inflationary pressure is rising, it aims at reducing aggregate demand with the use of interest rates and liquidity level. When it perceives inflationary pressure is easing, it can allow aggregate demand to rise with the use of the interest rates and liquidity levels.
By the way, there is the main problem that gives a hard time to the conduct of the monetary policy by Central Banks. It is not necessarily the private spending by consumers or businessmen that influence aggregate demand. The government spending can do it too. The danger is that, unlike the private sector, the government can stay “being insensitive” to interest rates or liquidity levels.
Here is a policy dilemma: Aggregate supply (through economic growth) needs to respond to growing aggregate demand from either the private sector or the government. And if economic growth is weaker due to weak supply-side factors, the economy has no capacity to accommodate aggregate demand. In a situation as such there is always “excess demand” and the potential for continuous inflationary pressure. As a result, the Central Bank has to carry out its monetary policy tightening which keeps the interest rates persistently high and liquidity levels tight.
Monetary policy puzzle
Do the consumers and businessmen respond to the monetary policy changes as we anticipate in economic theory? Not necessarily. There could be some other reasons for them to act and react even contradicting what we think. Deceleration of private credit expansion last year confirms this.
The Central Bank changed its monetary policy stance since the beginning of 2019 from monetary tightening to monetary easing. As a result interest rates started to fall. It is quite strange that the growth of bank credits to the private sector declined during 2016-2019, while the highest decline was reported in 2019.
It is an interesting question to explore as to why private credit expansion gets decelerated, particularly in the context of declining interest rates. If at least a significant portion of private credit is flowing into businesses, then the decline in private credit growth and the slowdown in growth momentum are, indeed, consistent and understandable.
The Sri Lankan experience is not strange, as the great monetary easing in the world has also produced similar results. The advanced countries which are still in trouble after the global financial crisis that commenced 10 years ago, have also been adopting monetary policy easing. Some of them have eased their monetary policy stance to the extent that the interest rates became zero and even negative. But they don’t seem to have achieved much success either in accelerating growth or getting out of the deflationary pressure.
Future direction
Sri Lanka’s interest rates are, however, still high, compared to international levels so that there is justification for the Central Bank’s attempt to move into lower interest rates in the medium term. And the Road Map 2020 indicates the possibility of a future reduction in interest rates.
The point is, however, that the Central Bank needs space to conduct its monetary policy and to achieve its desired outcome of inflation targeting. The space needs to be created with better management of aggregate demand through government revenue and spending on the one hand, and sustaining a higher growth momentum on the other hand. The first requires prudent policies under the fiscal management, while the latter under the development strategy.
What would happen if the Central Bank’s space is shrinking? There is a possibility for excess demand, leading to inflationary pressure. Then the Central Bank will be compelled to adopt tight monetary policy which would lead to higher interest rates.
(The writer is a Professor of Economics at the University of Colombo and can be reached at sirimal@econ.cmb.ac.lk).