The great inflation debate: Does money matter?

Has the Monetary Board – made up of the Governor, Secretary to the Ministry of Finance, and three supposed to be experts – failed in its duty to keep the public informed? Yes, because its job is to communicate with the public of all events, whether they are favourable or not. If it can earn the confidence of the public by speaking the truth consistently and continuously, its job of maintaining economic and price stability and financial system stability is made much easier. But if it adopts childish tactics by refraining itself from disclosing unfavourable information, it loses its credibility, and the public begins to suspect its every move even when they are guided by genuine objectives. This is the worst damage which the Board can do to itself, and the Board has now done it, apparently with no concern about its consequences

Inflation is raising its ugly head

The inflation rate as measured by the Colombo Consumers’ Price Index or CCPI that covers the prices in the Colombo District, has accelerated to 18.7% at end-March 2022, up from 15.1% a month earlier. The food inflation in this index has also jumped from 25% to 30%. These increases in food prices have not been fully reflected in the overall inflation because of the low weightage assigned to food category at 28.1%. 

Contrary to this, in the National Consumer Price Index or NCPI which covers the whole island has a higher weight at 44% for the food category. That index had recorded an inflation rate of 17.5% at end-February. Once its numbers are released later in this month, the national inflation might accelerate to about 20%. Whatever the index used, it shows the signs of setting a galloping inflation – a sudden jump in the inflation rate from month to month – in Sri Lanka. Though it is feared that it might degenerate to a hyperinflation – an increase in the inflation rate by 50% or more a month – the present case does not show evidence of reaching that level soon. 

Monetary Board abandoning its mission

The Central Bank had been in the practice of educating the public of the emerging inflation – a practice which it had started in 2002 – with a detailed analysis immediately after the data were released by the Census and Statistics Department. This was suddenly discontinued without notice or explanation in January 2022 after inflation began to raise its ugly head. Probably, the Bank’s Monetary Board which is responsible for maintaining economic and price stability would have thought that not disclosing information would be the best action to stabilise prices. In late March, the website of the Census and Statistics Department became inaccessible to public for an unknown reason. When the Central Bank too abstained itself from analysing inflationary trends, the public had to count on private analysts to do the job (See: https://economynext.com/sri-lanka-inflation-gallops-to-18-7-pct-in-march-2022-92331). But that was one day after the event. 

Monetary Board failing in its duty

Has the Monetary Board – made up of the Governor, Secretary to the Ministry of Finance, and three supposed to be experts – failed in its duty to keep the public informed? Yes, because its job is to communicate with the public of all events, whether they are favourable or not. If it can earn the confidence of the public by speaking the truth consistently and continuously, its job of maintaining economic and price stability and financial system stability is made much easier. But if it adopts childish tactics by refraining itself from disclosing unfavourable information, it loses its credibility, and the public begins to suspect its every move even when they are guided by genuine objectives. This is the worst damage which the Board can do to itself, and the Board has now done it, apparently with no concern about its consequences.

Twice guilty

The present Monetary Board is guilty on another count. When the former Governor W.D. Lakshman began to increase the money stock in the name of stimulating the economy but in truth because of his affiliation to post Keynesian ideology, now known as Modern Monetary Theory or MMT, and some economists he had brought to the Central Bank to serve on committees announced in public that money does not affect inflation, and consequently the currency depreciation, the Board made a stoic silence. When the present Governor Ajith Nivard Cabraal pronounced the same theory when he was the State Minister of Finance, the Board did not make any attempt to correct him. Instead, becoming a subservient yielding hand, the Board allowed the government to borrow heavily from the banking sector and money stock to rise to historically high levels. 

Accordingly, the Government’s net borrowings, that is after taking out the deposits of the Government out of its borrowings, increased by Rs. 4.2 trillion or 173% during the 25-month period from December 2019. Similarly, the money stock which the public loosely call ‘money printing’ too increased by Rs. 3 trillion or 40% during this period. The monetary theory which the Board had been following throughout would have told it that this huge increase in money stock was excessive compared to the near zero real economic growth which Sri Lanka had attained during this period. 

This standard monetary theory tells that such a huge increase in the money stock will cause inflation, and through inflation, currency depreciation. Validating this theory, the rupee has now fallen to its lowest level at Rs. 299 per dollar according to the official pronouncements and to a level much below in the black market. Inflation rate is now rising, and there is no assurance that it would begin to fall again. So, the Board is now reaping the product of the bad seeds it had sown earlier. 

Fuzz about money and inflation

What is this fuzz about money and inflation? Standard monetary theory recognises that money is a nominal asset – an imagination in the mind, for that matter – and helps an economy to exchange real things – things that can be consumed or used as an input for further production. Hence, when this imaginary thing is increased over and above the required level, the excess amount chases after goods and services, and, if supply does not increase, causes prices to go up.  A simple example is that suppose we have an economy with two goods, coconuts and this imaginary thing, money. If we produce 10 coconuts and we have 100 units of money, people will have to exchange money for coconuts and vice versa. Then, one coconut is priced at 10 units of money. Then, suppose that the money stock goes up to 200 while the number of coconuts remains unchanged at 10. 

The price now increases to 20. Suppose further that coconut output increases to 20 after the money stock increases to 200. Now, price of coconuts will remain at 10 as before. It is now clear that if the money stock is increased at the same rate as the increase in the real output, then, there is no inflation. It is this excess money that will chase after goods and services and lead to inflation. 

Hence, if a central bank is interested in increasing money without causing inflation, the rule of thumb is that it should set the money supply increase equal to the real economic growth. In the present case in Sri Lanka when there is only a close to zero real economic growth in 2020 and 2021, an increase in money supply by 40% will surely cause prices to rise quickly. 

Inflation leads to currency depreciation

This analysis can then be extended to identify how domestic inflation would cause exchange rate to depreciate or appreciate. This happens through the activation of the purchasing power parity or PPP, a theory first suggested by Swedish economist Gustav Cassel in 1916. According to PPP, when the domestic inflation is higher than the inflation in a benchmark foreign country, say USA, the exchange rate will adjust, in this case the local currency will depreciate, to maintain PPP. 

On the contrary, when the domestic inflation is lower than the foreign country inflation, to maintain PPP, domestic currency will appreciate. The exchange rate will remain stable when the inflation rates in the two countries under reference are equal. Since money supply leads to inflation and inflation leads to currency depreciation, the culprit is the money supply and the loose monetary policy adopted by the central bank. If the money supply has increased due to the government’s heavy borrowing from the banking sector, then, the perpetrator of currency depreciation is the government which has failed to maintain fiscal balance. 

How does PPP work?

Let’s take an example and see how this PPP works in practice. Consider the two countries, Sri Lanka and USA. Suppose a shirt in Sri Lanka is Rs. 100 and that in USA is $ 4. If the exchange rate is Rs. 50 per dollar, an American can bring $ 2, convert them to rupees at Rs. 100, buy a shirt and sell the same for $ 4 in USA. He can come back to Sri Lanka with $ 4 and buy two shirts for Rs. 200 he has got. He can sell the two shirts for $ 8 and buy back 4 shirts in Sri Lanka. This is called arbitraging – buying from the low-priced market and selling at the high-priced market. To eliminate this arbitraging trading, the exchange rate must now change. If the rupee appreciates to Rs. 25 per dollar, there is no incentive for the American to bring four dollars and buy a shirt. Thus, the purchasing power between the two countries is equalised by an appropriate adjustment of the exchange rate. 

Steve Hanke’s inflation dashboard

An economics Guru at the Johns Hopkins University in USA, Steve Hanke, has used this PPP theory to measure inflation rates in individual countries (See: https://www.cato.org/publications/commentary/hankes-inflation-dashboard-official-statistics-misrepresent-real-inflation). If the exchange rate is freely determined in the market, any change in the exchange rate, whether it is depreciation or appreciation, reflects the change in the inflation rate in the home country. The crucial assumption here is that the exchange rate is freely determined in the market having reckoned the inflation rate differential between the two countries concerned. 

If this assumption holds, then it follows that the exchange rate cannot change unless inflation rate has changed.  This permits a researcher to estimate the true inflation in a country by using the changes in the freely determined exchange rate. For instance, if the exchange rate has depreciated, according to PPP, the domestic inflation would have risen relative to the foreign country inflation. It is now possible to find that inflation rate via the exchange rate change involved. 

PPP is the best to measure inflation

According to Hanke, the inflation rates measured by governments by using a select basket of goods and services to compile consumer price indices is limited in scope. In contrast, the PPP basket includes all goods, services, and assets which are normally exchanged in a market. Hence, it is a more comprehensive basket presenting the bigger picture involving price changes. 

The basic methodology involves converting the domestic prices to select foreign currency by using the exchange rate between the two currencies. Then, it is reconverted to domestic currency by using the changed exchange rate. 

Since it is the exchange rate and price level differentials that are used, the PPP measure of inflation avoids the measurement errors and weighting problems which Sri Lanka has today. For instance, because of the low weight that has been given to the food category in CCPI in Sri Lanka, even though the food category has increased by 30%, it has not been fully reflected in the overall inflation rate. This is a serious weakness in the inflation data produced by the Government. 

Sri Lanka’s true inflation is much higher

By using this method, Hanke has estimated that Sri Lanka’s true inflation in March is 59% and it is much above the official inflation rate of 18.7%. However, he has used the official depreciation of the Sri Lanka rupee from Rs. 200 per dollar to Rs. 299 per dollar. Even at this exchange rate, there are no dollars available in the market which has spawned many black-market activities in dollars. According to some reports, the rates in the black market are as high as Rs. 375 per dollar. In the absence of reliable data on the black market, Hanke cannot use these numbers, but as reported by many importers, they have acquired dollars for imports through the black market at these premium rates. Hence, the actual inflation in Sri Lanka is much higher than what even Hanke has reported due to this reason and another reason. 

Waiting costs in queues should be added to prices

The other reason is that people have to wait in long queues to obtain essential commodities. The minimum period of waiting has been estimated as 12 hours. 

This is a real sacrifice which consumers must make to buy required goods. When the opportunity cost of standing in a queue is added to the monetary cost of the goods they purchase, the actual sacrifice by way of higher inflation is much higher. So far, no researcher has estimated this, but it is a significant element in the price inflation in Sri Lanka. It is this total cost that affects the welfare of consumers and not the mere money costs included in price indices. 

Twice guilty Monetary Board

What this means is that the Monetary Board is twice guilty of allowing Sri Lanka’s inflation to rise significantly, on one side, and permitting the collapse of the rupee in the foreign exchange markets, on the other. This it has done by keeping a mum when such spurious theories like MMT had been propagated by some connected to the Central Bank. 

(The writer, a former Deputy Governor of the Central Bank, can be reached at [email protected].)