Indolent Monetary Policy Extends Inflationary Pain
By Eyob Tesfaye (PhD)
Weather conditions are the terms that Ethiopian businessmen and women use these days to describe their sober mood. The situation has nothing to do with the weather but with the lingering uncertainty and apathy prevailing in the private sector. Many are those rising corporate stars and upcoming private sector actors who have been recently caught off guard by some of the recent policy measures that government officials keep on defending as necessary actions to quash illegal rent-seeking activities.
No wonder that there is a melancholic mood hovering over some circles that prefer shortcuts on their way up the economic ladder.
However, the overreaction of some officials and the chaotic manner that regulations are set is creating trouble not only for businesses but for the whole economy. Genuine investors who are excited by alluring investment incentives and business opportunities are discouraged by pitiful corporate standards.
Rampant corruption has also become a serious obstacle for private sector activities. Until recently, rouge government employees asked for bribes. Now, it is alleged that some of them have begun to demand shares in firms. Greasing the palms of low-level employees, too, has become part of daily life.
The messy stuff mainly occurs in transactions that involve land, public contracts, tax assessments, and bank loan approvals. Not surprisingly, some observers repeatedly have warned about the damaging effects of unbridled corruption, and there is no pleasure in being proven right.
During his recent appearances before MPs, Prime Minister Meles Zenawi has made it public that crooks operating in and outside of the government are becoming serious threats to the country’s development. His message can be interpreted as a tornado alert for those who forgot that a sword is hanging over their heads.
It is true that sustaining economic growth is hardly possible without weeding out corruption. It is also clear that corruption is currently one of the factors behind the yawning income gap in Ethiopia.
A cancer specialist usually does not bother about the possible goslings of the patient when she prescribes chemotherapy. Likewise, stamping out the corruption tumor requires strong action similar to that of chemotherapy treatment. After all, actions speak louder than words.
Apart from disgruntled businessmen and women, many private commercial banks are said to be in dejected mood. Until recently, private banks ensured their customers that their liquidity fountain will never dry up and that their lending capacity is enormous. They even went to the extent of conveying the impression that banks, like diamonds, are perpetual chattels.
Sadly, they were proved to be wrong. Following the introduction of the mandatory bill purchase by National Bank of Ethiopia (NBE), the liquidity bubble busted, resulting in all the clamoring for improvement.
While the private sector moves up and down like a rollercoaster, the runaway inflation continues to create growing jitters among the general public.
Ethiopia’s spiraling inflation is ascribable to global inflation, many economic pundits argue, which has an extended influence on domestic prices. Until recently, they were convinced that inflation was a temporary blip.
With due respect to their views and findings, the argument that puts imported inflation as the predominant cause of aggregate inflation does not hold water. This is not to say that imported inflation has no role in pushing domestic prices up. But, it is excessive money supply that outweighs imported inflation in igniting the inflationary fire.
The recent adoption of the zero money printing policy is aimed at reducing the growth of reserve money, and, thereby, improving the inflation situation. Apparently, the policy measure is based on the belief that the current inflation scourge is the result of loose monetary policy. It is evident from the policy measure that inflation, by and large, is a monetary phenomenon rather than a transmitted malaise.
There is no doubt that the central bank has failed to control the growth of reserve money, the principal liability on its balance sheet, on which it is supposed to have a lot of control.
Ironically, this is the same institution that ascribes, in its mandate and mission statement, to price stability as its main objective. So far, it has never abandoned its objectives. Nevertheless, due to the inability of controlling the growth in the supply, inflation continues to threaten the Bank.
The overriding objective of the monetary policy of most central banks is price stability. The benefits derived from the achievement of this objective are significant. An environment of price stability helps economic agents make better economic decisions.
Thus, central banks always keep a close eye on the movement and behavior of key monetary aggregates.
Reserve money is the operating target of the Bank, the monetary policy framework of the central bank clearly indicates. The objective, in order to regulate reserve money, is to achieve a desired rate of broad money growth in tandem with gross domestic product (GDP) growth.
Nevertheless, due to the high growth in the reserve money or base money, broad money has surged up well above the growth in real GDP. The fast increase in broad money has led to excessive domestic credit expansion, which, in turn, has flared up inflation.
Money velocity, too, has increased and, together with inflation, exacerbated inflation expectations. Nonmonetary factors on which the central bank has no control have also added fuel to the fire.
Reducing the growth in reserve money will certainly help tame inflation, even if it is not going to pull it down in the short-term. Nevertheless, regulating the growth in the base money alone is not enough to curb the double-digit inflation. Reserve money is not the silver bullet to force inflation to its knees.
Chasing a GDP growth rate of 11pc a year or more, together with properly guiding the inflation expectations of citizens and businesses, requires a radical transformation of the central bank and its monetary frameworks. Sometimes, instead of fixing the pipe, it is better to fix the institution that is responsible for making the pipe.
It is totally unfair to belittle the achievements that the Bank has made so far. However, as the economy continues to grow and get complex, it is essential to upgrade its otherwise less potent monetary policy instruments and indolent money markets. The central bank’s monetary policy instruments include open market operations, reserve requirements, discount policy, foreign exchange operations, interest rates, and moral suasion. Added together, all of these policy instruments have the adequate monetary firepower to keep inflation at bay.
A close scrutiny of the treasury bills market reveals that the yield in real terms is significantly well below the rate of inflation. It, instead of serving as a major part of open market operation, has become a source of financing the government’s budget deficit. The fear that higher Treasury bill yields would place a great burden on the government has diluted the effectiveness of the otherwise effective monetary policy instrument.
This situation has been exacerbated by the absence of secondary markets. In many emerging economies, central banks do not get involved in Treasury bill markets. Rather, they manipulate open market operations in secondary markets, rendering themselves free to buy and sell any amount that they want to mop up or inject.
As long as the government’s vested interest remains keeping the costs of servicing its debt low, the chance for the emergence of secondary markets is remote, affecting the move toward better indirect monetary policy instruments.
Foreign exchange operation is also one of the central bank’s instruments for controlling the money supply. A sale of foreign exchange has a similar impact on reserve money as an open market sale of Treasury bills. The success of foreign exchange sales as a monetary policy instrument, however, depends on the supply of foreign exchange available through improved export proceeds, increased remittances, donor inflows, and other windfalls.
A pulsating money market, capable of sending signals about the cost of money, requires an active interest rate policy. Nudging up the interest rate either increases the supply of grain or fruit, some policymakers and academicians believe. Every time the central bank jacks up the interest rate, it chokes up growth and increases the cost of debt servicing by the government.
Negative interest rates have encouraged speculative investment to overshoot, empirical evidence, however, indicates. They also remain conduits to transfer wealth from savers to borrowers. Due to the lack of incentives to save, many potential borrowers prefer to go on a spending spree or consume food and drink, as if there is no tomorrow.
It is true that the government has to boost growth further and keep on investing in the ever-expanding infrastructure. Yet, keeping interest rates negative will in the long run harm growth. The gradual increase in the interest rate may increase the cost of debt servicing and is not palatable for the government. Unfortunately, powerful medicines never taste sweet.
Since frequent changes in the interest rate has the capacity to damage growth, it is, however, better to hike up the rates gradually so that they can send signals to all economic agents about actual or anticipated monetary developments.
In addition to augmenting the monetary instruments and the money markets, it is essential to create harmony between monetary and fiscal policies. Harmony does not mean being subservient to one another. It instead has to feel like a symphony. Different musicians play different instruments, but in effect create a blend that produces the best music.
While creating harmony between monetary and fiscal policies, it is important to be careful not to burden monetary authorities with agendas that may conflict with their own objectives.
Finally, it is hardly possible for a central bank to tame inflation by simply setting monetary policy on autopilot. It is also not enough to take a policy measure and sit back to wait for the outcomes. Monetary policy must be dynamic and actively responsive to changing circumstances. For instance, the monetary policy committee of the Bank of England meets every week to gauge policy reaction in line with the prevailing economic situation.
The gradual enhancement of the monetary firepower of the central bank and bolstering of the efficacy of the money market is crucial in getting the inflation genie back into the bottle. This, however, calls for a radical paradigm shift and a brazen audacity to bring fundamental change.