Flexible does not mean feasible

Due to the abandonment of rule-based monetary policy in favour of highly discretionary flexible inflation targeting and flexible exchange rate, Sri Lanka has caused three currency crises – in 2015, 2016, and 2018 – and is currently in the middle of the third. Real effective exchange rates, yield curves, lending and deposit rates, and growth targeting – through the output gap – were all handled under flexible inflation targeting.

The International Monetary Fund has been urging numerous nations to adopt flexible inflation targeting, which is a more flexible type of monetary policy than that used by successful inflation-targeting nations like Sweden, New Zealand, and Australia.

Macro-economists may create money at whim and then impose exchange and import controls since neither the general public nor lawmakers have access to information about the operational framework or the actions of the domestic operations department. It is exceedingly difficult to prohibit open market purchases of Government assets from serving as an indirect source of Central Bank credit as long as such transactions are permitted. Despite the nation being forced into external default in the previous several years by printing money to target a prospective output, the promotion of growth has now returned as output gap targeting.

Most recently, a significant commodities bubble and inflation rise that aggravated world hunger are now referred to as the “cost of living crisis” in Western media, which gives unaccountable Central Banks a pass. The nations with “flexible exchange rates” that have fallen have been worst hurt. Although the fact that Sri Lanka’s pegged Central Bank accepts Treasury notes is now widely known, less is known about how macroeconomics will still generate money to lower rates through open market operations. The Fed broke the Bretton Woods system, started the Great Depression, brought about the Great Recession, and put an end to the gold standard.

Critics claim that during the previous ten years, inflationary open market operations were frequently employed to target potential production, create excess liquidity in the money markets, start balance of payments deficits and foreign borrowing, and then cause output shocks when the brakes were applied. Instead of allowing the credit system to respond to the balance of payments, Sri Lanka’s Central Bank implemented import and exchange restrictions to preserve the country’s exchange rate while funding the budget deficit.

According to a leading economist and former Central Banker, flexible inflation targeting is a corrupted version of the original and does not align with the original purposes of Sri Lanka’s Monetary Law Act. Targeting an output gap with printed money is also contrary to the original intentions of the Monetary Law Act. Under the so-called Modern Monetary Theory, the Central Bank acquired enormous amounts of Treasury notes in 2020.

There may be no historical precedent for it in Sri Lanka, but the Central Bank’s Treasury bill stock has surpassed Rs. 900 billion, Central Bank credit to the Government has exceeded reserve money, and forward exchange rate premiums are negative despite a run-on foreign reserve due to low rates. The public is becoming more aware of the Central Bank’s policy mistakes and the import controls that follow. Import restrictions suggest that the people, not the Central Bank, which is mismanaging reserve money, is to blame for the depreciation of the currency rate.

Keynesian gatekeepers are active in think tanks in Sri Lanka as well, preventing change, sustaining monetary instability by anchoring competing regimes, and ensuring that macro-economists have the authority to devalue currencies and levy regressive inflation taxes on the poor.