All Central Banks print money-CB

Economists and analysts who have attributed the high inflation rates in the country to flaws in the CB's monetary policy do not have a proper understanding of economic principles and the responsibilities of the Central Bank (CB), a Bank economist said .

In an interview with The Sunday Times FT this week, CB Director of Economics Research Dr P.N. Weerasinghe said the CB has the authority and the responsibility to make monetary policy decisions after reviewing the economic position. 'It doesn't mean that the decision we take now is wrong," he said, referring to the CB's announcement that it has made a downward revision of the reserve money targets.

Addressing the ongoing debate on money printing, Weerasinghe argued that analysts who say that CB is putting too much money into the economy, thereby increasing inflation is wrong. "Money printing is the money the CB is putting out to the economy for the smooth transaction of economic activity," he said.

"All Central Banks are doing this. It is the responsibility of the CB." Weerasinghe explained that reserve money is determined after analyzing key variable such as economic growth, inflation, the overall balance of payment and credit to the government. He said in certain years such as 2004 and 2006, the CB had put out more than what was required for several reasons but that this was not the case last year where the required amount was 20.8 percent and the CB actually put out 10.2 percent.

Weerasinghe said that in April 2008, the CB reviewed its original predictions based on the average price of oil being around US$90 to US$95 and found several deviations. Core inflation predictions were also based on that assumption. He added that it was also unexpected within the first four months of 2008 that food prices in the world market would increase significantly. "All countries are being affected by this.

We didn't expect this kind of headline inflation rising to 24 percent or 25 percent in April," he said. "That is why we reversed the monetary policy and made it much tighter. We are concerned with core inflation pressure and this is the action any Central Bank would take under these circumstances. Some of the analysts said we have got the targets wrong but it's a reflection of their misunderstanding of monetary policy implementation. We have to review positions every month and make a monetary policy decision."

Weerasinghe also said some analysts have mistakenly argued that the CB should have tightened the reserve money targets when economic growth for 2007 was 6.8 percent as opposed to the expected level of 7.5 percent. "If growth is slowing down, reserve money targets should be relaxed and not tightened," he said, adding that this is exactly what the United States Federal Reserve is doing. "They [US] are not concerned with inflation but with growth and are bringing down policy rates. If we see economic growth is slowing, we should increase our targets and relax the reserve money targets. However, we tightened them because we are more concerned with the underlying inflation, not economic growth."

Weerasinghe said he doesn't see a major concern in economic growth because the CB is expecting a favourable supply side shock to the economy and predicts growth will be around 7 percent. Even if it comes down to 6 percent, he said it is not much of a concern for the CB because the main concern is inflation. "We want to bring down inflation so we have to curtail a certain amount of growth." He said that even in 2007, growth was lower due to tightening of the monetary policy. "That is the price we have to pay."

At the beginning of 2008, the CB expected core inflation to be around 10 or 11 percent but with headline inflation rising, inflation could be higher than expected. Weerasinghe said the expected inflation level has not been announced to the public because it is uncertain.

"It is difficult to project where petroleum prices are heading and where food prices are heading and if they will go further up or down." However, he did say that the CB is expecting inflation to decelerate in the second half of 2008 from the current 25 percent. "We are expecting it to go down to about 18 or 19 percent. It is difficult to say but it will definitely not come down to 10 or 11 percent." He added that the full impact of the tightened monetary policy will be felt on inflation in about 18 to 24 months but there will be a partial impact in the short term. He stressed that factors such as increasing petroleum and food prices are beyond the control of the CB and is not a monetary phenomenon.

The introduction of the New Colombo Consumer Price Index, the CCPI(N), was needed because the old index, the CCPI, inflation measure is wrong. According to Weerasinghe, the major problem with the CCPI was that food items were weighted at over 70 percent when the actual consumption of food is around 40 percent. Based on the new index, food consumption is weighted at 46 percent which Weerasinghe feels is also still too high, based on a 2002 consumption expenditure survey conducted by the Department of Census and Statistics.

He said the CCPI(N) will be revised in the near future to more accurately represent food consumption patterns in Sri Lanka. He added that the old index is still in use because it has been linked to several wage contracts but that publishing the old index must be abandoned.

Weerasinghe said it is true that the CCPI(N) excludes alcohol and tobacco but that analysts are bringing this argument to discredit the new index. He said that it is correct to argue that if people are consuming alcohol and tobacco, it should be reflected in the consumption pattern but that the government has taken a policy decision through it's 'Mathata Thita' program and it has therefore been excluded.

However, Weerasinghe said that even if alcohol and tobacco were included in the CCPI(N), it would probably not make any significant change in inflation. In the CCPI, he explained that alcohol and tobacco consumption was around 1 or 1.7 percent. With the high prices of both alcohol and cigarettes, he said the consumption share of those two items must be even less now. "If you take the average consumption basket, the expenditure on alcohol and tobacco is probably less than 1 percent."

Weerasinghe also said that he doesn't see a need for the government to go in for another bond issue. Instead, he explained that the government is going in for syndicated loans, have opened up 10 percent of its treasury bonds to get external finance in addition to an Iranian line of credit they can utilize. He said that in order to maintain development projects, there are several diversified instruments available depending on interest rates and global finance conditions for the government to choose from. Weerasinghe added that the government is promoting Public Private Partnerships (PPPs) instead of borrowing from overseas.

On the issue of treasury bonds which were opened in 2007, Weerasinghe said that when the bonds mature, the government still has to find financing irrespective of whether or not they are open to foreigners. "When bonds and bills mature, the government still has to find money," he said. With rupee bonds, Weerasinghe said that foreigners are taking a risk because their returns and in rupees, regardless of depreciation. However, opening up to foreigners is creating external debt. "When you borrow more from external sources, then there are interest payments and they make take the interest income out of the country. Those are the risks but there are benefits as well."

Response to Dr. P.N. Weerasinghe’s comments

In response to the interview with the Central Bank (CB), an independent view-point on the key economic arguments made by the CB was provided by Principal Researcher at the Point Pedro Institute of Development, Dr. Muttukrishna Sarvananthan:

Sarvananthan said he agreed with the CB's view that analysts who state that the CB has gotten their targets wrong is actually a reflection of their misunderstanding of monetary policy implementation and that in fact, the CB has to review its positions every month and subsequently make monetary policy decisions.

Sarvananthan also agrees with the CB view that reserve money targets should be relaxed and not tightened if growth is slowing down. He further said that to the best of his understanding of monetary policy implementation, the interest rate instrument (what the US is using) is more effective than the reserve requirement instrument because the latter is difficult to monitor. By keeping the repo and reverse repo rates static for more than one year (since February 2007), Sarvananthan argues that the CB has given priority to economic growth rather than containing inflation.

If at all the CB is keen on reducing inflation, Sarvananthan said the CB has to increase the policy rates which have been frozen since February 2007. He added that at the moment, there is negative real interest rate in the market (i.e. inflation is higher than the nominal rate of interest). For example, the weighted average prime lending rate (18 – 19 percent) is lower than the rate of inflation (> 25 percent). Therefore, he said that naturally the government, private sector and the people will continue to borrow more and more thereby fuelling inflation.

Sarvananthan said that the CB's comment about economic growth not being a major concern because it is expecting a favourable supply side shock to the economy while predicting growth to be around 7 percent is spurious but may also come down to 6 percent. Sarvananthan said this shows that the CB is not confident that the growth rate would be 7 percent in 2008 despite claims by the CB Governor. He added that the Asian Development Bank (ADB) has forecast 6 percent growth in 2008.

Sarvananthan added that it is true that in order to bring down inflation, a certain amount of growth must be curtailed and that growth in 2007 was lower due to tightening of the monetary policy. However, he also said that 2007 growth was lower than 2006 because the intensification of the conflict took its toll and that during the first half of 2007, the agriculture sector recorded negative growth.

Sarvananthan disagreed with the CB's expectation that inflation will decelerate during the second half of 2008. He said the CB made the same point early last year that inflation will decelerate in the latter half of 2007 and drop to single digit by the end of the year when in fact, the reverse happened.

He also added that if the CB says it will take 18 to 24 months for its monetary policy to yield results in terms of lowering inflation, then it is not serious about arresting inflation. Sarvananthan said Sri Lanka needs shock therapy and not expect people to bear the cost for two years. If the CB is expecting to bring down the cost of living in two years time, then it is failing in one of its core duties which is maintaining price stability. However, he agreed that rising petroleum and food prices are beyond the control of the CB and is not a monetary phenomenon.

On the issue of the of the CCPI and CCPI(N), Sarvananthan said the old index was flawed but that the new one also has serious flaws. He further added that according to the 2002/3 HIES, consumption of alcohol and tobacco takes about 7 to 8 percent of the total household income and that the 1 or 1.7 percent referred to by the CB is the weight given for alcohol and tobacco in the old index.

He further pointed out that the flaws in the CCPI(N) are more than the exclusion of alcohol and tobacco.
Sarvananthan pointed out that on the public private partnerships (PPPs), there are actually hardly any takers. He said there are so many vulnerabilities in the economy for the private sector to partner with the government.