‘inflation targeting’ oxymoron: Bellwether
Under planned ‘flexible inflation targeting’, Sri Lanka is supposed to target an inflation index, intervene to prevent speculation in forex markets and target a real effective exchange rate index
Sri Lanka is supposedly heading for ‘inflation targeting’ or ‘flexible inflation targeting’, whatever that discretionary oxymoron means.
From statements made so far, the Central Bank is set to target a mish-mash of at least three separate anchors, one of which involves being hostage to monetary policy errors of large trading partners.
According to statements made by Central Bank Governor Indrajit Coomaraswamy, under planned so-called flexible inflation targeting’, Sri Lanka is supposed to target an inflation index (a domestic anchor), intervene to prevent any ‘speculation’ in forex markets (an external anchor based on US monetary policy) and target a real effective exchange rate index (another external anchor based on the monetary policy of multiple trading partners which may change their exchange rates).
Such a multiple anchor targeting system goes completely against the very basic principle of inflation targeting.
There is a great deal of technical hocus pocus and econometric pyrotechnics surrounding monetary policy to confuse innocent members of the public who lose their shirt to inflation ( and currency depreciation).
It is easy to forget that, at its core, a central bank is simply a legalised swindle. Even though central bankers use big words, high inflation central bankers are essentially counterfeiters wearing clothes, engaging in a destructive and harmful act that is deemed a crime if done by an ordinary citizen.
To get an idea of the dangers of the proposed triple-mandate framework, it is necessary to understand the nature of central banking and to know what is meant by an inflation anchor which these institutions target. To do so, we have to de-mystify the essential fraud of monetary policy.
Inflation and free banking
If we fast-forward through early forms of money and come to the last 500 years, metals like gold (most of Europe) and silver (most of Asia) were the most useful types of money that helped build large empires and international trade.
The ‘monetary policy’ in such a system was simply ‘rarity’ or ‘scarcity’. Gold or silver supplies simply could not be expanded by a monetary policy committee to generate inflation. Roughly speaking, gold supplies used to expand about two percent a year.
In such a system, gold or silver discoveries, debasing coins with base metals like copper, striking the sovereign’s seal on copper or other more plentiful metals created inflation. But, debasement was easily detectable, and usually retribution on the leaders were swift.
But, it is with paper money that inflation and currency depreciation crept up like a thief in the night, and the printers of such money developed ways of obfuscating the truth, though there were celebrated cases of pioneering printers being sent to the other world.
Modern central banking comes from Jewish banking, which was later adopted by countries with Christian monarchs, such as the Netherland and the UK.
Initially, free banks developed where people deposited gold (no interest was paid) and the banks started to lend the gold that was sitting there to others. Instead of delivering gold, it was easier and safer to send a ‘banknote’ that the bank cleared.
Banks found that only a portion of gold would actually move out of the bank in this way and even loans could be made with a banknote that people were happy to exchange.
The next jump was easy. A bank can write a note even without gold backing. This is what is called reserve money in a paper money system. The monetary base could now be expanded at will, by each such ‘free bank’ to provide credit and earn interest.
The temptation to do so came when credit demand was strong. By printing money, a credit cycle could be fired to new heights. The restraint in such a system was the gold price.
When too much money was given in credit, the gold price tended to rise as banks gave too much credit (or, in international trade, gold was exported) and customers demanded their gold back.
The banks then had to put the brakes on or go bust with no gold to return to customers. Eventually, the big banks who were less greedy and knew how to slam the brakes early, survived. Hence, the Goldman Sachs and Rockefellers of Europe and later the US.
Gold-backed central banking
In a central banking system, the state through its coercive powers gives one bank the sole right to print money, which is called a note-issuing monopoly.
When the Bank of England was initially set up in 1694 (as a private bank) to create and loan printed money to King William, there was no monopoly.
One can see that, even though the British system with the Bank of England was called the ‘gold standard,’ it was actually a gold-linked standard where the monetary base could still be expanded almost at will. Or, at least until people started to demand their gold back as prices rose (inflation) or gold was exported (currency depreciation) as the specie price rose.
Central banks were given other tools to keep them alive even if they made mistakes that would have busted a free bank.
These included a legal tender law that prohibited the use of competing currencies, taxes on gold or silver trading that made them too expensive to transact, and note-issuing monopoly.
As long a central bank was bound to return gold for paper when demanded (a convertibility undertaking), it had no discretion to expand the monetary base in perpetuity. To do so, it had to ‘suspend gold convertibility’. This is similar to stopping the defending of a peg and ‘floating’ a currency.
The public would generally not allow a private-owned central bank to suspend convertibility without criticism or return less gold than was originally deposited, stealing the rest. But currency depreciation that state-run central banks now routinely engage in and people accept as a given.
That was what kept the sterling- and gold-linked central banks on the straight and narrow despite several credit bubbles and collapses, some of which spanned the world, including then Ceylon.
Ceylon’s 1848 uprising – along with several around the world – came with the collapse of the so-called British railway bubble that depressed commodity prices (coffee in Ceylon), compelling the Colonial government to raise taxes (service tenure had then been abolished) as revenues fell.
The ‘Currency School’ of economists pushed through the note-issuing monopoly the Bank Charter Act of 1844 as part of a well-meaning type of restraining measure.
The Currency School were the classical economists at the time, wanting rules to control the Bank of England when the so-called Banking School was peddling heavy Mercantilism, advocating discretion.
Gold as a domestic anchor
The Bank of England and the Sterling started to lose its supremacy shortly after World War I was declared in 1914, as the British Treasury started to print money and gold convertibility was suspended.
France also suspended convertibility of the Franc, with German nationalism ending the century-old Pax Britannica, plunging the world into war. Attempts to return to the gold standard after the war without raising rates sufficiently led to a bubble in the US and later the Great Depression in the gold area.
The end of World War II saw Britain on its knees, with the Bank of England, France and most of Europe without gold. Most of the gold was with the US Fed. Until World War II, most Western central banks were pegged to gold.
Each bank targeted gold in the domestic market through its convertibility undertaking. When they printed and fired a commodity bubble, gold prices went up and people demanded gold back, leading to a contraction.
The market – the community – forced a correction when credit demand went up.
Gold was the domestic anchor for inflation. Inflation as defined by classical economists did not have a Mercantilist definition like now, involving some general price rise defined by a continuously manipulated index calculated by a state agency.
Inflation was an expansion of the money supply, which brought several mal-effects including rising prices and mal-investment.
Although gold was a ‘domestic anchor’, the metal was internationally traded. As a result, all central banks effectively targeted the same anchor.
This is why, during the gold standard or gold-linked central banking period, international exchange rates were relatively stable, unless convertibility was suspended.
Dual anchor Bretton Woods
After World War II the US Treasury (led by Harry Dexter White, who was later found to be a Soviet spy) dragging economist-turned-Mercantilist John Maynard Keynes by his short hairs formed the disastrous dollar soft-pegged system based on dual anchors.
Keynes was unceremoniously overruled in his attempt to create a uniformly inflating ‘Bancor’ global currency, which would have prevented balance of payments crises, but would have created big global bubbles and collapses instead.
The US State Department used its diplomatic clout to persuade countries to adopt the soft peg, which would shift the anchor of many countries in the former British Empire to the Dollar from the Sterling. This is why State still has virtual veto over IMF programs.
At the time, of course, the Sterling was having trouble with war-weakened Britain on its knees after money printing. Rationing and price controls were in place in the UK. Trading with the dollar area was subject to exchange controls.
Added to all this was the idea that interest rates could be manipulated at will to boost growth, while keeping a peg. However, Dexter White and his cronies knew this was a pipe dream, which is why the IMF bailouts were set up.
But, Sri Lanka, like many other post-independent nations, was a victim of the times, with JR Jayewardene being seduced by the mirage of discretion to manipulate interest rates.
Sri Lanka was, at the time, a part of the ‘Sterling area’, with a currency board linked to the Sterling through the Indian rupee. Originally, the Indian rupee was silver based, but was later made into a gold currency.
Sri Lanka (Ceylon) created a currency board in 1884 after the note-issuing Oriental Banking Corporation failed amid another global monetary upheaval (the most proximate reason in Ceylon for the collapse of the Oriental Bank was the ‘exchange rate risk’ coming from borrowing in gold and lending in silver, which is a lesson for the Central Bank of Sri Lanka not to give forward cover to banks).
A currency board had no discretion. It only issued money when foreign exchange flowed in. This can push rates down. Interest rates rose when there was an outflow. The interest rate floated.
Under a currency board or hard peg, inflation and monetary conditions in general were linked, or anchored, to the mother central bank. If the mother central bank followed good policy, the anchored country would also do well.
Export powerhouses like Hong Kong still use this arrangement. Singapore has a modified currency board also with a floating rate. All small financial centres use an orthodox currency board.
Some systems, like in, Dubai mimic a currency board, raising rates with the anchor currency, which is less credible, but seems to work.
In a currency board, the exchange rate is the single external anchor or hard peg. The rupee was fixed one-to-one to the Indian rupee under this system until the Central Bank was created in 1951/2 to join Bretton Woods, and all hell broke loose afterwards.
The Ceylon Central Bank targeted the US dollar as the external anchor and printed money by purchasing Treasury bills to keep rates down when credit demand went up, generating high inflation and frequent BOP crises. Through the peg, it also imported US inflation, while creating its own.
Currency boards were abandoned on the argument that such countries suffered downturns when the anchor currency country did – such as when commodity bubbles burst.
But, with the Central Bank, more crises were created in Sri Lanka between the cycles of the anchor currency.
Fertile conditions in Sri Lanka, including unemployment and poverty from high inflation that came with deficit spending, created conditions that supported several armed uprisings, with nationalism and socialism (socialist deficits in particular were made possible with the abolition of the currency board) adding to the witch’s brew.
Over 1971-73, when gold prices rose to untenable levels with money printing during the Nixon administration (for the Vietnam War, and other reasons involving political meddling in the Fed), the Bretton Woods system broke up, with the contradictory policy of dual anchors.
Sri Lanka closed the economy, generating poverty and severe malnutrition of poor kids, while beggars died on the roadside. The Central Bank owned almost all Treasury bills. Draconian exchange controls were inplace.
Developed countries started to independently float currencies (recognising that intervening led to sterilised forex sales that became a vicious downward spiral), while Singapore and later Hong Kong recreated their currency boards after experimenting with floats.
But, there was no credible anchor on which to base monetary policy under floating rates. This led to the so-called ‘Great Inflation’ period of the 1970s.
In the early 1980s, severe tightening adopted by the Fed under Paul Volcker using money supply targets as a domestic anchor saved the dollar. In the UK, the Thatcher administration did the same. However, targeting money supply is tricky, as its calculation is also difficult.
The US moved to a rudimentary inflation targeting system; but unfortunately, with a dual mandate, involving growth and a misleading core inflation target, the Fed tripped it up spectacularly with the ‘mother of all liquidity bubbles’ after 2000, generating the now-familiar Great Recession.
After Bretton Woods broke up, Germany and Japan (hard hit by hyperinflation in recent memory during World War II), inflation was brought down with tight monetary policy and exchange rates were strong. Exports boomed.
Even within the Bretton Woods system, German monetary policy was tight, helping create the so-called German Economic Miracle, while the UK suffered a series of BOP crises called ‘Sterling Crises’, until Margaret Thatcher came. In the 1980s, Britain struggled with different systems. It tried to ‘shadow the Deutsche mark’ and failed. The soft-peggd European Exchange Rate mechanism was created amid warnings from Sir Alan Walters (who was Thatcher’s first advisor and played a part in creating the HK Monetary Authority).
His advice was unheeded, he resigned, and the ERM naturally collapsed.
It was aorund this time that the single anchor ‘inflation targeting’ system was invented in New Zealand.
There is a great deal of technical hocus pocus and econometric pyrotechnics surrounding monetary policy to confuse innocent members of the public who lose their shirt to inflation, who should look at closely.
Sri Lanka’s primary trouble, like all other (soft) pegged countries, is that it started targeting two anchors from the time it joined the Bretton Woods.
It has kept on the system, while financing the budget with printed money and sterilizing interventions with more printed money, even after Bretton Woods broke up, and developed countries and several East Asian nations learned their lesson.
The pegs in some Gulf countries are not like Bretton Woods, although some have mistakenly termed it Bretton Woods II. Dubai for example, does not practice true independent monetary policy. It tracks US policy rates.
Meanwhile, in Sri Lanka, conflicting monetary and exchange rate policies (targeting rates to keep to some unknown inflation number) while also ‘managing the exchange rate to reduce volatility’ led to chaos and repeated, BOP trouble.
Frequent excuses were given for the failure. Oil prices were a favourite scapegoat. Droughts, floods, supply shortfalls, external shocks. You name it. Any neo-Mercantilist cost-push reason was ok, provided it was not blamed on Central Bank incompetence and loose policy.
Economist Steve Hanke from the John Hopkins University in Maryland, USA, explained this clearly in 2008, when inflation in Sri Lanka, coupled with that of the US rose close to 30 percent and indices were scrapped.
“At the end of the day, inflation is always a monetary phenomenon. This is, of course, the case in Sri Lanka,” he wrote.
“The problem resides at the Central Bank. It doesn’t have a credible anchor. In consequence, it lacks the discipline to control inflation and contain inflation expectations.”
“Monetary discipline (and ultimately fiscal discipline) can be delivered if a monetary authority has either a credible internal or external anchor.”
“It must be stressed that these anchors are mutually exclusive: one or the other, but not both.”
To target a domestic anchor (an inflation index), the exchange rate must be allowed to float according to the currency injected to the banking system by the domestic operations department of a central bank through its various windows and liquidity tools.
To target an external anchor, interest rates must float and the exchange rate must be fixed.
In a central banking system, the state, through its coercive powers gives one bank the sole right to print money, through its note-issuing monopoly
New Zealand inflation targeting
Faced with high inflation, New Zealand – a relatively small country that some people even doubted could float its currency effectively – decided to target one anchor: a domestic inflation index.
Since New Zealand started the process (Sweden also has a history), even people like Ben Bernanke – a spectacularly failed central banker who by virtue of being a ‘depression era scholar’ pushed his boss – into creating the bubble that caused the Great Recession, has made pronouncements on inflation targeting.
As can be expected from an interventionist, Bernanke has tried to dilute the phenomenon and mislead the public that inflation targeting is a process or framework involving substantially more discretion or flexibility than what was originally envisaged by its architects.
The architects of the scheme, however, realised the real problem.
The problem could not be solved with more flexible, discretionary or monetary policy hocus pocus.
The problem was institutional failure coming from excessive discretion and the lack of accountability at the Reserve Bank of New Zealand, and elsewhere.
“In New Zealand, the development of inflation targeting owed a lot more to Harvard Business School than to the Chicago monetarists we are sometimes accused of following,” the then deputy governor of the Reserve Bank of New Zealand said in a landmark speech in 2010.
“The Reserve Band New Zealand was just one of a number of state agencies in the process of undergoing reform in the late 1980s, and the guiding principles for those reforms came from the text books on corporate governance rather than from those on monetary policy.”
The basic ideas were as follows:
a) A clear objective was set – Inflation between 0-3 percent.
b) Responsibility was set with the governor personally, rather than a committee.
c) He was made accountable –If the target was exceeded, the board could sack him.
When someone is made accountable by law and also given the independence to carry it out, it worked.
In Sri Lanka, it is quite laughable. Central bankers even get inflation-protected incomes.
That may make Sri Lanka’s Central Bank less eager to keep rates low and generate monetary chaos.
In New Zealand, the entire inflation targeting process was made transparent.
The Central Bank targeted a consumer price index, which the public could feel.
It was not some pie-in-the-sky core inflation that nobody feels, like Bernanke – who now makes pronouncements on inflation targeting – did and busted the entire world.
The Reserve Bank of New Zealand also created an index of non-tradable items to watch. This was a useful tool, as it separated traded commodities like oil – which tended to be influenced by US policy – from other items.
According to Central Bank Governor Indrajit Coomaraswamy, Sri Lanka will target a Real Effective Exchange Rate Index to eliminate any perceived ‘overvaluation’ of the currency that can hurt exports, manage the exchange rate and punish speculators, as well as targeting a domestic anchor.
Sri Lanka’s REER as calculated by a the central bank, rose to around 109 in January 2017 after the 2015-2016 currency collapse and has since fallen to a little over 106.
“Once we get the REER to a 100, it will take some time, [the framework is] to manage the exchange to keep the REER around there,” Coomaraswamy was quoted as saying to reporters.
“We are not going to let the currency go suddenly and things like that.”
He was late quoted warning traders not to speculate.
That traders successfully speculate is a false idea. No trader can ‘speculate’ against a currency unless the central bank prints money and gives it to the traders to buy extra foreign currency than is available consistently.
An international fund with dollars cannot bust the domestic currency. The fund would need domestic money. That excessive money has to come from the domestic operations of a central bank.
In the absence of money printing, any trader or fund manager would have to retire hurt, like George Soros, the man who failed to break the Hong Kong currency board, found to his cost.
The idea that excessive volatility would not be allowed in currency markets sounds suspiciously like a managed float or external anchor.
‘Excessive volatility’ refers to any volatility against one intervention (effectively the anchor) currency, which is the US dollar in Sri Lanka. Among central banks, the US Fed for all its faults is still a better ‘hard currency’ than most.
The REER index is a slightly different animal, or it may be more appropriate to call it a zoo.
An effective exchange rate or nominal effective exchange rate (NEER) measures the appreciation or depreciation of a currency against a basket of currencies rather than a single currency like the US dollar.
A real effective exchange rate adjusts the NEER for inflation in the currencies in the basket. If Sri Lanka’s inflation is higher than some other currencies – which is usually the case – the REER would rise.
The currencies in the basket are trading partners. This is then, by definition, a Mercantilist tool from the same stable as the J-curve, Phillips Curve and other such nonsense.
The reason inflation targeting uses a single domestic anchor is not to be hostage to any policy errors coming from an external anchor.
Just like China, which had a silver anchor, escaped the worst of the Great Depression of gold-standard countries, Australia, New Zealand and Canada, which independently appreciated their currencies, escaped the worst of the Great Recession.
The European Central Bank, which ‘talked down the currency’ and gave into pressure from exporters to avoid appreciation, and kept looser policy, suffered.
If large trading partners have bad monetary policy and inflation goes up (say in India or China), Sri Lanka’s REER would look good, even if Sri Lanka’s inflation was also high.
On the other hand, if a currency of a strongly weighted country suddenly collapsed due to monetary policy errors of their making (like China did recently), Sri Lanka’s REER index would appreciate.
To get the index down, Sri Lanka has to depreciate, creating more inflation in the future as crawling pegs always do. If Sri Lanka’s inflation is already high, such a course would be disastrous.
If Sri Lanka tightens policy as required by a proper inflation targeting regime, it is quite likely to cause an appreciation of the currency in the short term and inflation can come down eventually.
But, in the short term if the exchange rate appreciates (if we have a floating rate) the REER would look worse, requiring a depreciation under the proposed triple mandate.
This column has already shown that the US claiming that East Asian currencies are ‘undervalued’ is a blatant lie. It is the neo-Mercantilist basis of the nationalist arguments of the likes of Donald Trump and Steve Bannon that have been repeated so often that some people believe them.
That the REER has anything to do with BOP crises is also false.
During the Asian financial crisis, Hong Kong’s REER went up as much as 162%, as currencies around the territory collapsed.
Later, as inflation in other countries picked up, the REER fell. Its REER has rarely been at 100 percent. It is now over 120 percent, with China and Malaysian currencies weakening in recent years. Eventually, inflation in these countries will catch up, or China may appreciate (which may be happening already) and the Hong Kong REER may fall.
This is why targeting a REER makes a central bank hostage to policy errors of other monetary authorities. All has not stopped Hong Kong exports from rising to 300 percent of gross domestic product at times. Neither has its exchange moved an inch for almost 27 years.
Taiwan’s REER is the same.
Admittedly, one successful country supposedly does target a basket – probably heavily weighted with US dollars. That is Singapore.
But, Singapore has no policy rate. The other problem is that various methods and weightings based on existing trade patterns are used to calculate the REER.
Frequently, these are re-based. This is not unlike the wild goose chase engaged around calculating the correct monetary aggregate to target inflation in the 1980s.
Australia and New Zealand have similar inflation-targeting regimes and floating rates. Australia tends to show a REER below 100 percent, while New Zealand shows one above.
If New Zealand depreciated to keep-up-with-the-Jones’ monetary mistakes, its inflation would go haywire.
Australia is a commodity exporting country with a strong exchange rate. In fact, in the popular press, the Aussie is called a ‘commodity currency’, which is almost the last word in Mercantilism. Currencies behave based on the underlying monetary policy, not trade.
Trade-linked monetary policy
Nobody doubts the good intentions or integrity of Sri Lanka’s current Central Bank governor who is one of a last breed of true public servants that are almost extinct.
But, his focus on running monetary policy to facilitate trade (boost exports) is the last word in Mercantilism.
No inflation-targeting central bank governor should be worried about exports or trade deficits, which were the hunting grounds of the classical Mercantilist, or the current account deficit, which is the hang up of neo-Mercantilists in this century.
“I think we have seen confirmation that monetary policy is a poor instrument with which to target a balance of payments deficit,” then Reserve Bank of New Zealand Governor Donald T Brash said in 2000.
“New Zealand has had a current account balance of payments deficit in every year since 1974.”
“During the mid-nineties, the Reserve Bank was blamed for causing an increase in the deficit by tightening monetary policy, with a resultant strong appreciation in the exchange rate and pressure on the export sectors of the economy.”
“If monetary policy is tightened, domestic demand is reduced, and with it demand for imports and goods that could be exported.
“This helps to reduce the deficit. But, the firmer monetary policy also tends to push up the exchange rate, and this tends to slow the growth of exports and encourage the growth of imports.”
The opposite happens when policy is loosened. The value of a vibrantly exporting economy is that it gives a bigger market, providing more opportunities to earn an income and import better goods at cheaper prices.
To export competitively, investment and know-how have to come. It is not relevant whether goods or services are exported. Service exports tend to be better paying and require knowledge workers unlike the grunt labour of manufactured exports.
If there is a race to the bottom to keep an ‘undervalued exchange rate’, expect brain and brawn drains. Sri Lanka already cannot fill vacancies in export sectors, where the lack of new investment into capital-intensive production has kept wages low.
In any pegged country where wages have been destroyed by past currency depreciation, the inflation index is going to climb faster than the US or some other high-wage country as the traded sectors become more productive, unemployment falls and wages in the non-traded sectors are pushed up.
The same phenomenon is captured in the Balassa-Samuelson effect.
A race-to-the-bottom undervalued crawling peg, like Indonesia or Philippines or Mexico, will simply produce mass migration, not a financial centre or a high-wage economy. It is also likely to defeat the very objective of keeping inflation low.
Higher inflation with currency depreciation means political discontent will rise. In a true inflation-targeting regime, the currency goes up and down nominally and otherwise, sometimes showing an ‘overvaluation’.
This column is based on ‘The Price Signal by Bellwether‘ published in the August 2017 issue of the Echelon Magazine. To read Bellwether columns as soon as they are published, subscribe to Echelon Magazine at this link. The i-tunes app can be downloaded from here.