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Wider adoption of inflation-targeting practices expected in SL – IMF says

Many view the current monetary policy setting in Sri Lanka as an interim stage in a move toward wider adoption of formal inflation-targeting practices in which inflation (more precisely, expected inflation) is the intermediate target, instead of either some monetary aggregate or the exchange rate, according to an April 2011 International Monetary Fund (IMF) Working Paper titled "Towards Inflation Targeting in Sri Lanka", by Rahul Anand, Ding Ding and Shanaka Peiris, of the organisation's Asia and Pacific Department.

Further, the document suggested that the Central Bank of Sri Lanka (CBSL) concurs with its opinion, stating: "In fact, the CBSL’s medium-term strategy considers such a transition and the annual roadmap for monetary and financial sector policies for 2011 and beyond (CBSL 2011) takes a first step by looking beyond monetary aggregates alone and signaling a gradual shift toward targeting inflation more directly."

A market place. Consumer prices have been rising sharply in recent times

Pioneered in 1990 in New Zealand, Inflation Forecast Targeting (IFT) occurs when monetary systems target price levels or rate of inflation rather than exchange rates. The method is said to be empirically proven to counter sudden inflationary / deflationary shocks, by appreciating/depreciating a currency as a response to international deflation/inflation, so that internal prices remained more or less stable. It has so far been successfully used by central banks in the United Kingdom, Canada, Australia, South Korea, Egypt, South Africa and Brazil amongst others.

The IMF working paper also further stated that "[although] volatility in supply-side prices make it difficult for a country like Sri Lanka to target any precise inflation figure, the Central Bank can aim to keep headline inflation in the mid-single digits and support the authorities medium-term plan of consolidating macroeconomic stability. The [Central Bank] could also explore the possibility of targeting or referencing a lower and narrower target range for a measure of core or underlying inflation which is less volatile and susceptible to commodity price shocks."

Transition to inflation forecasting
Considering all these factors, the document also offered up a "practical model-based forecasting and policy analysis system (FPAS) to support a transition to an inflation forecast targeting regime in Sri Lanka."

Elaborating, the White Paper indicated the "estimated FPAS model sheds new insights on the monetary transmission mechanism and impact of exogenous shocks on the economy, and thus provides a guide to implementing an IFT regime in Sri Lanka. The FPAS model provides a relatively good forecast for inflation and a framework to evaluate policy trade-offs. The model simulations suggest that an open economy inflation targeting rule can reduce macroeconomic volatility and anchor inflationary expectations given the size and type of shocks faced by the economy. In addition, monetary policy rules can help guide the appropriate monetary stance."

This model is said to use "information on eight key macroeconomic variables for Sri Lanka running from 1996Q1 to 2010Q3: GDP, CPI, oil price inflation, interest rate, real effective exchange rate, fiscal balance, public debt and credit to the private sector. The 3-month Treasury bill rate is used as a proxy of the nominal interest rate and the real exchange rate against the U.S. dollar is used as proxy for the real exchange rate."

Giving some background to the situation, the White Paper noted "Sri Lanka has been broadly following a monetary-targeting framework, particularly since the adoption of the more flexible exchange rate regime in 2001. Inflation control has, however, remained somewhat elusive. Headline inflation has averaged above 10 percent since 2001 and peaked at 28 percent in 2008 before falling to single-digit levels in 2009-10. Now that the Central Bank has built credibility by bringing inflation under control, the Central Bank could move toward a less rigid monetary policy framework that targets inflation more directly taking into account a wide range of factors including exchange rate movements."

Also, according to this document, "there has been limited analysis of the sources of shocks (Wimalasuriya 2007 and Duma 2008) and monetary transmission mechanism in Sri Lanka (Thenuwara 1998, Thenuwara and Jayamaha 2002), providing little guidance on the optimal implementation of monetary policy."

Tightly-managed exchange rates
Further pointed out was that the "conduct of monetary policy focuses primarily on the supply of, and demand for, reserve money (CBSL 2010). As a result, interest rates and open market operations represent an instrument to achieve a given monetary target, although the interest rate channel has become an important mechanism of transmitting monetary impulses as interbank money markets and secondary markets for government debt have developed, as in most other emerging markets.
The CBSL has also, at times, tightly managed the exchange rate, further complicating monetary management. Finally, the dominance of commercial banks and information asymmetries are likely to mean that the credit channel is a prominent part of the monetary transmission mechanism (Bernanke and Gertler 1995)."

At the same time, the White Paper notes that, with monetary targeting, "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. Based on expected developments in the macro economy, the CBSL designs the monetary program which sets out the desired path for monetary growth and determines the path of quarterly reserve money targets necessary to achieve this monetary growth. The CBSL would then conduct its Open Market Operations (OMO) within a corridor of interest rates formed by its policy rates i.e. the repurchase rate and the reverse repurchase rate, to achieve the reserve money target. Policy rates are periodically reviewed, usually once a month, and adjusted appropriately, if necessary, to bring the reserve money to the targeted path."

A better option, according to the document, is a "gradual transition to a flexible IFT regime" and to back this position up it cites that in recent times "inflation targeting has come to be viewed as an appropriate regime for emerging market and developing economies and much experience has been gained on how to transition to full-fledged inflation targeting." Further, it added that a "cursory analysis as to whether CBSL’s monetary-targeting framework should continue to play a major role in Sri Lanka by introducing money in an ad hoc manner" has indicated that IFT would be better for "minimizing macroeconomic volatility than a monetary-targeting framework"

However, it is suggested that many barriers exist "for an emerging market non-inflation targeting country to develop a more systematic approach to monetary and exchange policy." These include "developing a more open and market-friendly approach focused on a single operating target, fostering financial and external stability, and developing the institutional setting and political backing, to transition to a single nominal anchor." On the other hand, changes are said to "lead to consistency between objectives and over time and, ultimately, more policy credibility."

Additionally highlighted, "Sri Lanka like many other emerging market inflation targeting countries has a managed float exchange rate regime and intervenes relatively frequently... Frequent interventions and the absence of a transparent implementation framework can make it more difficult for the markets and public to assess the objectives of foreign exchange interventions. While the CBSL publishes foreign intervention data regularly with a short lag, the relative lack of transparency on the objectives of foreign exchange market intervention whether they are aimed at supporting inflation targeting or managing the exchange rate in and of itself is not clear.

For example, it could be difficult for the markets and public to assess whether excess volatility or the level of the exchange rate is the focus of interventions because what is regarded as excess volatility is usually not defined and the intervention pattern is not always consistent with volatility developments."
Also emerging, a "large operational role for the exchange rate can weaken the effectiveness of its operations" and "greater interest rates volatility in turn reduced the effectiveness of the interest rate channel of monetary policy in Sri Lanka." Further, the possibility exists that foreign exchange interventions, misaligned with domestic monetary operations, "complicates the attainment of policy objectives and communication (e.g. unsterilized intervention is inherently inconsistent with an IFT regime)."

In keeping with this, the document advised that "conflicts that can arise from the more active role of the exchange rate for open economy inflation targeting countries can be alleviated to some extent by a well-designed implementation framework (Stone and others 2009). Transparency of the role of the exchange rate with respect to objectives, procedures and ex post evaluation offers important advantages for open economy inflation targeting countries. Central banks can explicitly communicate that foreign exchange intervention aimed at influencing the exchange rate is separate from domestic monetary operations intended to steer expected inflation, including by conducting sterilization separately from foreign exchange intervention.

Transparency facilitates the signaling channel of intervention. Central Bank communication of the purposes of interventions for purposes other than monetary policy (reserve management, fiscal agent transactions, foreign exchange market development) can ensure that these actions are not seen as related to policy. Of course, there are limits to the transparency of foreign exchange implementation. Real time reporting of intervention operations during periods of high uncertainty, and in the context of relatively thin markets, can lead to speculative behaviour that contributes to exchange rate volatility, and compel the Central Bank to react to market expectations, either to validate them or to counteract them (Stone and others 2009)."

On an overall basis, the White Paper suggests: "Developing an integrated and systematic approach to the role of the exchange rate in policy decision-making can facilitate the transition to inflation targeting. This requires setting up a more systematic process for integrating the analysis of economic and financial developments into the policy decision-making process (see Laxton and others, 2009). In this context, a FPAS model can play an extremely useful role in bringing together information and judgment in a coherent and logical manner. Effective use of the model in the policy process requires establishing good two-way communications between the senior management of the Central Bank and the economists involved in forecasting and policy analysis (see Laxton and others, 2009). Reducing the weights of the exchange rate in the reaction function over time can help transition towards inflation targeting. For an open economy inflation targeting approach, this means reducing the importance of the exchange rate and output and raising the weights on the inflation target in interest rate policy...

Domestic operations
In many emerging market non-inflation targeting countries like Sri Lanka, asymmetric financial market development leads foreign exchange interventions to play a more important role than domestic operations. Although the foreign exchange markets of many emerging market non-inflation targeting countries are thin and underdeveloped compared to those of inflation targeting countries, they are more developed relative to their own domestic markets. The use of foreign exchange operations by the Central Bank as the main instrument can lead markets to assume that exchange rate management is a priority even when this is not the case. Financial market development facilitates policy implementation and can reduce policy conflicts at relatively minimal costs and effort. The payoff for market reforms is especially high for Sri Lanka given the relatively low level of money and bond market development."

Additionally, the document notes; "Foreign exchange market development often requires changing the Central Bank’s role from market-controlling to market-supporting (Ferhani and others, 2009). Reducing the role of the Central Bank often involves moving toward more market-supporting trading mechanisms e.g., eliminating or widening exchange rate bands), shifting market-making from the central bank to commercial banks, and developing a market-supportive framework for the Central Bank’s own foreign exchange operations. However, emerging market non-inflation targeting countries often face a 'chicken and egg' dilemma of market development against exchange rate policy flexibility (Ferhani and others, 2009). The dilemma is that foreign exchange market development is inhibited by lack of movement in the exchange rate, but moving toward a more flexible exchange rate regime is constrained by the thin market. The active management of the exchange rate also creates a disincentive for the development of banks risk management instruments.

This dilemma can be addressed by market development measures to develop risk management instruments. Further, financial regulation and supervision should continually account for foreign exchange risk. Market players should begin to find it in their interest to drive development as the central bank reduces its role and the exchange rate becomes more flexible. Forwards and other foreign exchange derivatives (e.g., FX swaps) should also be encouraged to facilitate hedging of foreign exchange risks and support market liquidity. These instruments also require a deep money market."
At the same time; "Money and bond market development reduces the need to use foreign exchange intervention for reasons unrelated to monetary policy and facilitates sterilization. Ferhani and others (2009) identify a sequence of reforms needed to support the development of money market operations which must be tailored to each country’s particular circumstances. A liquid money and government market is necessary to develop a benchmark yield curve for the effective transmission to monetary policy. The call money market rate has been very volatile in Sri Lanka in the past due to weaknesses in the monetary policy and liquidity management framework, which to a large extent has been addressed through reforms to the open market operations and standing facilities in 2008-09 (see Saxegaard and Peiris 2008).

Government securities
However, the term money market remains illiquid and interest rate swaps bench-marked to the Sri Lanka Inter- Bank Offered Rate, (SLIBOR) are permitted but inactive (Peiris 2010). Reviewing and improving the Master Repo agreement and primary dealer (PD) system, particularly allowing PDs to diversify activities by consolidating their accounts could help. While the size of the government securities (G-Sec) market in Sri Lanka is quite large, liquidity remains very low due to a lack of benchmark issues and the prevalence of buy-and-hold investors. With regards to the former, the size of each benchmark security needs to be sufficiently large, usually a significant multiple of the average transaction size. Banks face a 20 percent Statutory Liquid Ratio held mostly in G-Secs without marking-to-market while institutional investors such as the Employees Provident Fund, Employees Trust Fund and National Savings Bank hold a large share of its assets in Government securities and until maturity, thus hindering active trading (Peiris 2010)."

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