Money printing and inflation

By Anil Perera, Economist, Money and Banking Division, Economic Research Department, Central Bank of Sri Lanka

Several articles were published in the media raising allegations against certain Central Bank of Sri Lanka (CBSL) activities, particularly money printing. These allegations highlight two main facts. First, the CBSL has resorted to "irresponsible wide scale money printing to finance the fiscal deficit of the Government." Second, "the excessive money printing has fuelled high and persistent inflation causing serious threats to the socio-economic stability of the country".

The CBSL has issued several press releases elaborating the process of printing money and the actual developments during the recent period, considering the "adverse impact that could be felt by the economy due to the generation of such negative sentiments as a result of these myths and misperceptions". However, some analysts continue to claim the same argument despite the CBSL's explanations.

Mandate
Maintaining economic and price stability has become one of the core objectives of CBSL. At present, the monetary policy framework of CBSL is based on a monetary targeting framework where the final target, price stability, is to be achieved by influencing changes in broad money supply which is linked to reserve money through a multiplier.

This monetary targeting framework is operated through a monetary programme, taking into account developments and projections in economic factors such as the expected fiscal and balance of payments developments, economic growth, desired levels of growth in credit and inflation. Based on these factors, the monetary programme sets out the desired path for monetary growth and determines the path of quarterly reserve money targets necessary to achieve this monetary growth. Targets are designed to ensure that the CBSL releases reserve money that supports to facilitate a growing flow of transactions.

Money printing
In Sri Lanka, CBSL is the primary source of money supply. Although the CBSL has a stock of minted coins and printed currency notes in its vaults to be issued as money, they do not become money until they are possessed by the public as assets.

Printing money can be explained as releasing money into circulation by the CBSL, done entirely based on fundamental reasons. The fresh money issued by the CBSL is called reserve money. This is called "reserve", "base" or "high-powered" money as commercial banks can create deposits based on reserve money, which are components of the broader definition of money supply, through their process of creating credit and deposits.

Reserve money consists of currency issued by the CBSL, commercial banks' deposits and government agencies' deposits with the CBSL. These are liabilities of the CBSL and are shown under the liability side of the balance sheet. As per accounting fundamentals, these have to be backed by the assets of the CBSL balance sheet.

There are two main channels of releasing reserve money from the CBSL to the economy, i.e. by acquiring domestic assets and foreign assets. The acquisition of domestic assets by the CBSL takes place through lending to the government and/or commercial banks. One way of government borrowing is selling its Treasury bills to the CBSL. Also, according to the Monetary Law Act the government can obtain an amount equivalent to 10 per cent of its estimated annual revenue as provisional advances from the CBSL. Accordingly, there will be an injection of new money from CBSL to the economy through these operations.

The government also maintains deposits with the CBSL. The difference between the borrowings mentioned above and the deposits is called "net credit to the government (NCG)". Similarly, money will be injected to the economy when commercial banks borrow from the CBSL or sell domestic assets in their portfolio such as Treasury bills to the CBSL. Net credit to the government and commercial banks by the CBSL when net-off to the other assets and liabilities of the CBSL are called net domestic assets (NDA) of the CBSL. NCG is the main component in the NDA of the CBSL.

The second channel of releasing new money to the economy is acquisition of foreign assets by the CBSL. When the CBSL purchases foreign exchange from the government or commercial banks it has to inject new money, which will lead to an expansion in reserve money and vise versa. Therefore, the net change in foreign assets, which is called net foreign assets (NFA) of the CBSL, contributes either to expand or contract the reserve money.

Each year, the CBSL sets out its monetary programme based on the expected developments in all major sectors in the economy. One of its main purposes is to project the amount of new money that the CBSL should inject to the economy in that particular year. Usually, the new money injection should be sufficient to meet the expected expansion in economic activities and should tally with the nominal growth in gross domestic product.

The planned injection of money needs to be entirely backed by the aforementioned increases in NDA and NFA. For any increase in domestic assets above the expected level, there should be a corresponding decline in foreign assets, and vise versa in order to meet the planned amount of new money injection in a particular year.

In recent times, some analysts have made attempts to interpret the increase in NCG as an increase in reserve money. However, it is clear and obvious that the NCG is only a part of reserve money or new money injection and increase in NCG alone cannot be interpreted as money printed by the CBSL. It is necessary to examine the changes in both NDA (which include NCG) and NFA in order to have a clear idea about the amount of new money injected to the economy in a particular year. CBSL's strategy is to maintain and control the overall amount of money issued to the economy by looking at the developments in both NDA and NFA of the CBSL and not only the component of NCG.

Money printing in recent times
In the recent past, the annual percentage increases in new money had been set at around 15 per cent per annum. Reserve money growth rates have largely been on par with expected economic growth rates and inflation rates, except 2004 and 2006. The reserve money target for 2007 was set at the stringent growth rate of 11.7 per cent or, in value terms, an increase of Rs. 27.7 billion to Rs. 267.6 billion. However, the actual amount of reserve money as at end December 2007 was even below at Rs. 264.4 billion and the increase was entirely due to the increase in NFA. In fact, the actual reserve money growth during 2007 was at 10.2 per cent, which was lower than the tight target set at the beginning of the year. Therefore, the CBSL has only issued Rs. 24.6 billion as new money to the economy throughout the year.

Relationship between NCG and inflation
It is observed that some analysts have tried to point to a strong and linear relationship between NCG and inflation. As such, efforts have been made to find out the correlation between NCG and inflation. Those also interpret the results to claim that CBSL's money printing has caused inflation in 2007.

It is not correct to use NCG as "money". Hence, the correlation between the level of NCG and CCPI inflation is spurious. The relationship between inflation and monetary aggregates is not that simple and is usually observed with a considerable time lag. All existing empirical evidence suggests that any change in monetary aggregates influence inflation with a significant time lag.
It is also not correct to compare a stock variable and a flow variable together. NCG is a stock given as at a particular date and inflation is the change in price level during two periods.

If there is a need to find out such a relationship, it would be more realistic to compare the change in NCG as against the rate of inflation. It is well observed that, the change in NCG and inflation measured by the CCPI (N) - New Colombo Consumers' Price Index (and even the old index) show a weaker correlation. In fact, the correlation co-efficient is only 0.26 per cent, which means there is no robust relationship between the two variables.

Factors affecting inflation
The changes in money supply are a primary causal factor affecting price stability. Hence, there is no argument about the harmful impact of excessive monetary expansion. Definitely, excessive monetary expansion is an evil as it creates high and persistent long-term inflation.

The classic explanation of demand pull inflation is that there is too much money chasing too few goods. As more money is created, it is owned by the people and businesses and they would proceed to spend it, thereby making efforts to buy more goods than produced and more than those available for purchase. If the money supply continues to increase above the desirable levels, people would keep bidding each other for the increasingly scarce goods and prices would keep increasing. In summary, the answer to the question whether inflation is a monetary phenomenon, in the long run, is yes. No serious inflation can take place without rapid money growth.

But at the same time, in a modern economic system, perhaps money is not the only culprit. The point is that in the case of cost -push inflation (due to supply constraints or wage pressures) sometimes the money supply may be the follower rather than the leader in the inflation process. In the meantime, low productivity also has a huge impact on generating inflationary pressures. The lower productivity allows cost increases that flow through to product prices and thereby raises inflation. The lower productivity growth thus represents a negative supply shock that generates inflationary pressures. Hence, it is obvious that inflation is driven both by supply and demand side factors. Long-term trend in inflation is due to demand pressures; however, short-run fluctuations are due to supply side factors.

Recent behaviour of inflation
The recent movement in inflation in Sri Lanka is largely explained by supply side factors. Sri Lanka's inflation has been suppressed to a certain extent in the past through subsidized fuel prices. Since those prices have now been adjusted in line with international market prices, a one-off increase in inflation appeared. In fact, inflation was on a downward trend during the first half of 2007 benefiting from the lagged effect of tight monetary policies pursued since 2004. It surged beyond expectations and projections during the second half of the year largely due to factors beyond the control of the CBSL.
Inflation is expected to decelerate to around 10 - 11 per cent by end 2008 and to a single digit by end 2009 with the phasing out of the one-off impact of reforms. This would be facilitated by the moderation of already addressed demand driven pressures.

However, such inflation projections have been based on certain assumptions such as international commodity prices remaining stable during the year as predicted by experts. Any changes may cause deviations in inflation from projected levels as in 2007.
Therefore, although the CBSL is confident about the curtailing of demand pressures, it needs to be cautious about the price pressures that may arise through supply side shocks.

CBSL needs to vigilantly monitor each and every movement in the economy and sense the pulses of policy measures. If any adverse developments are perceived in the inflation front, particularly through deviations in money, credit and fiscal variables, CBSL is required to adopt timely and precautionary measures since "the price stability is not everything, but without price stability everything is nothing!"