ECONOMYNEXT – The International Monetary Fund has told the central bank target the middle of a policy corridor, among other inflationary operations, in a new technical assistance report urging the agency to go for a single policy rate.
A slew of inflationary operations has been suggested for the central bank, which has already caused untold suffering to the people through the currency depreciation coming from its policy rate.
Millions have been forced to leave the country of their birth to get jobs in stable nations in the Middle East which are free from the centrally planned policy rate.
Bureaucratic Desires
The IMF urged the central bank to defy market credit conditions and push the bureaucratic policy rate.
“Central Bank of Sri Lanka should start replacing the current two policy rates with a single policy rate to strengthen the signaling of monetary policy and improve the ability of CBSL to steer market rates towards a desired level,” the IMF said in its technical assistance report.
The advice comes as the IMF itself has given the central bank a foreign reserve collection target in its program.
Meanwhile using the new Central Bank Act, macroeconomists have persuaded ousted President Ranil Wickremsinghe to allow the agency to create 5 to 7 percent inflation, though the public was promised no goal independence.
“This will also help CBSL to simplify communication by clearly indicating the monetary policy stance,” the IMF said.
“The mission also strongly advises against using restrictions to limit access to standing facilities.”
Liberal (indiscriminate) standing facilities are among the most-deadly liquidity operations which allow banks to lend without deposits, not only endangering the external sector of a country that is yet to come out of external default, but also lender to run asset liability mis-matches.
The technical assistance proposed one week printing, which would make bank even more comfortable to lend without deposits giving false comfort to banks.
Sri Lanka’s state banks have used the central bank facilities liberally in the past, while the best managed foreign banks tend to lend less in rupees than they get (have positive balances in the standing deposit facility) and are generally net sellers in the forex market.
Even the US Fed has aggregate limits on its liquidity operations, as it is engaged in quantity tightening after firing the worst inflation bubble in 40 years with excess liquidity and low rates.
Mid-Corridor Debacle
“OMOs should steer interbank rate close to mid-corridor and improved liquidity forecast will prevent large interest rate volatility,” the IMF report claimed.
“Allowing the operational target to move depending on market conditions rather than policy decisions, undermines its usefulness in anchoring expectations and clarity for communicating the central bank’s monetary policy stance.”
Analysts have pointed out that the central bank triggered a currency crisis without a war particularly in 2015 and 2018, by dumping excess liquidity into the banking system to target a middle-of-the-corridor rate despite operating a reserve collecting central bank.
Critics have pointed out that by busting the currency from 131 to 184 and imposing un-necessary burdens on the people through higher energy and food prices, macro-economists discredited the free trade agenda of the 2015-19 administration.
After suddenly hiking rates and triggering output shocks and two stabilization crises, the central bank shattered the entire economic policy of the so-called Yahapalana administration, and eventually toppled it, they said.
In 2015 for example, to target the mid corridor, (claiming inflation was low under IMF-backed data driven monetary policy), large amounts of liquidity were dumped through various term and outright open market operations including by taking on maturing bills outright from banks, giving permanent liquidity to finance imports without deposits.
Push it Baby
The technical assistance report noted that the monetary transmission has weakened after the crisis.
“The monetary transmission has weakened and needs to be restored,” the report noted.
“The debt restructuring process, financial stability issues, weaknesses in operational design of monetary policy implementation and the dysfunctional interbank market have all contributed to this erosion.
“The important role of policy rates to influence long-term rates as well as deposit and lending rates has not only weakened, but the CBSL has had problems having full control of domestic interest rates.”
Sri Lanka had three currency crises in a row from 2015 to 2022 due the Central Bank’s well-oiled ‘transmission mechanism’ and the country returned to stability and the currency appreciated due to market rates.
The corrective market rates are usually excessively high due to the need to overcome the broken confidence in the domestic currency (forex shortages and parallel exchange rates) which trigger capital flight.
Chronically high nominal rates coming from the flexible inflation targeting and the flexible exchange now and the money supply targeting and basket band crawl policy (a type of REER targeting) before the 1990s have destroyed fiscal metrics well.
The reason Sri Lanka recovered from the currency crisis, and has refrained from going into second one so far is the market rates are working, and the central bank is not mis-targeting rates with inflationary open market operations.
This is partly due to a ceiling on domestic assets of the central bank set in the IMF program.
In all countries under IMF programs, whether it is Bangladesh, Kenya, or Ghana, or Argentina, the archetypical sterilizing central bank, currencies have collapsed within programs and people have come out to the streets due to reserve-collecting central banks targeting a policy rate.
Based on the initial economic projections in IMF documents, the exchange seemed to have been forecasted around 400 to the US dollar.
However, to the credit of the current central bank leadership, the exchange rate has been held. The IMF has classified the regime as ‘other managed’. However analysts say with a foreign reserve target, the exchange rate has to be ‘managed’ with interventions.
Whether or not the exchange rate weakens or not depends on whether money created by dollar purchases are mopped up through domestic asset sales (a sterilized purchase) or whether the central bank is ready to sell the dollars it purchased if liquidity is left alone (an unsterilized sale).
The Policy Rate
The bureaucratic policy rate is decided without any regard to the balance of payments, in countries like Sri Lanka, despite not having a floating exchange rate regime.
The policy rate, centrally planned by a few bureaucrats as we know it today involving indiscriminate injections to all comers to push the policy rate far and wide (transmission mechanism) instead of to individual counterparties that discounted bills, was originally proposed by Scottish Mercantilist John Law.
Law said at the time some were advocating lowering rates by a legislation (an administration measure or price control).
“Such a Law would have many Inconveniencies, and it is much to be doubted, whether it would have any good Effect,” John Law wrote in Money and Trade Considered in 1705.
“Indeed, if lowness of Interest were the Consequence of a greater Quantity of Money, the Stock applyed to Trade would be greater, and Merchants would Trade Cheaper, from the easiness of borrowing and the lower Interest of Money, without any Inconveniencies attending it.”
He was opposed by more prudent advocates of money in England and was not able to start the policy rate at the time. About a decade later in 1716 he was able to persuade the Duke of Orleans to open a note issue bank in France.
Banque Generale, later Banque Royale began to lose reserves in 1720 and convertibility was suspended (floated like in March 2022) and the entire scheme collapsed.
The modern policy rate and open market operations suddenly emerged 200 years later inside the Fed in the 1920s with no public debate unlike in the 18 and 19 centuries.
The roaring 20s bubble and the Great Depression followed.
As the policy rate spread to other central banks from the late 1920s, currencies collapsed in the 1930s, with the Sterling in 1931 leading the way.
Keynesianism, so-called beggar thy neighbor policies, protectionism and the 1934 Gold Reserve Act in the US came as in its wake.
A similar prohibition on gold holdings was imposed by John Law on French citizens in the last days of his bank.
The Success of the Narrative
Before the centrally planned policy rate and the ‘transmission mechanism’ the entire yield curve did not move up steeply when short term rates went up to stop liquidity injections in either free banking or central banking without external trouble.
When the Bank of England’s discount rate went up steeply to maintain convertibility neither long term East India bond nor British government Consols rocketed up like bonds rocket up today.
Modern state central banks which default on the currency and depreciate are not closed like Bank Royale. Instead, new ‘monetary policy’ , a euphemism for money printing, is devised.
There is no accountability, as a result they keep making the same mistakes again and again with operational frameworks suited to clean floating central banks coming from IMF technical advice or academic papers.
Neither forex shortages nor inflation, nor social unrest stops.
These central banks also go to the IMF again and again, with structural reform programs ending half-way as governments are ousted even before the currency starts to depreciate again due to aggressive open market operations, or ‘exchange rate as the first line of defence’ style actions.
Before the ‘transmission mechanism’ it was not possible for a few central bankers to push up the entire yield curve and de-stabilize the finances of an entire nation and the government as an examination of pa
It is unique achievement of the success of the narrative pushed by present day central banks, the media and academic papers, that central banks with exchange controls, which point to deeply a flawed operational framework in any case, continue to run with impunity, blaming imports, the current account deficit, lack of exports or some other real economy phenomena for monetary troubles coming from their inflationary OMO or the transmission mechanism.
The exchange controls, as well depreciation and repeated bailout programs, is an indictment against not just the soft-pegged central bank but the IMF technical know-how and the false doctrine it spread with technical advice.
Legislators, Presidents, Prime Minister and the public are helpless against the juggernaut of the centrally planned policy rate or the single policy rate shorn of a wide policy corridor for markets to work for the minimum to account for default risk. (Colombo/Aug26/2024)