Coordinating fiscal and monetary policies for managing inflation
Wednesday, 3 December 2008
Dr. Salehuddin Ahmed
IN the backdrop of rapid globalization and accelerating economic growth, it is important to identify various channels through which global integration can affect inflation and monetary policies in South Asian countries. Certainly, greater integration of any economy means that inflation in the domestic economy is more open to external pressures coming from outside the country. The general economic argument is that globalization helps to reduce inflation everywhere.
However, in the case of South Asian countries, this proposition may not be entirely tenable. The reasons lie in many factors including high import dependence, increased global pressure of excess demand, and weak productivity growth in the domestic economy, and persistence of significant structural and institutional rigidities. Moreover, the causalities have country-specific characteristics including wide variation in relative roles of demand and supply side factors across countries and over different periods in the same country. In addition, widening internationalization of inflation in South Asia also means diminished role of central banks in managing domestic inflation.
In the context of a positive association between excess growth in money supply and inflation, it is held that money supply growth affects growth in real GDP in the first round while the second round effect is felt by inflation. Therefore, to avoid inflationary pressures in the economy, formulation of monetary policy needs to be based on a comprehensive consideration of the developments in the real and financial sectors of the economy. Since high growth in money supply can trigger inflationary pressures, it would be important for the central banks to remain cautious about the growth of money supply and its implications on the economy
A significant issue in adopting appropriate monetary strategy is the relevance of inflation targeting (IT) regime in South Asian countries. Since the 1990s, IT has emerged as the dominant monetary policy paradigm in several countries--developed and developing ones alike. Many other countries often pursue 'inflation caps' especially in the context of IMF programmes which can be viewed as a first move toward IT. It is often maintained that IT institutionalizes good monetary policy, increases the transparency and accountability of the central bank, and provides guideline for other government policies. It also helps to shape private sector expectations that reduce the uncertainty and cost associated with adjustment to low inflation regimes. The gains of IT regime are, however, not well established and there are views that IT may entail several economic costs such as cost of targeting low inflation, cost of high real interest rate, cost of conflict between IT and balance of payments, and cost of conflict between IT and financial stability. In South Asian countries, anti-inflation strategy based on IT appears difficult to implement under the present circumstances especially in view of the problems in fulfilling the institutional requirements for IT, existence of balance of payments vulnerability, and prevalence of shallow financial markets that restrict the sensitivity of interest rate changes in achieving macroeconomic outcomes. Moreover, policies of pursuing low inflation alone may not be desirable in South Asian countries as this might lock the economies in low employment equilibrium with consequent adverse impact on poverty.
One of the important functions of the central banks in South Asia is to regulate and supervise the financial system with the views to safeguard the soundness of the financial system and absorb possible adverse shocks that could be detrimental to economic growth, and improve the efficiency of the financial system and deepen financial intermediation with a view to channelling an increasingly greater volume of financial resources to the productive sectors of the economy. Thus vigorous pursuit of developmental and promotional roles through targeted interventions in the financial sector is important for central banks in South Asia. This, however, need not lead to any compromise on the core objectives of price and financial stability. In order to play desired roles in national development, it is time for the central banks in South Asia to come out of the 'black box' of conventional targets and include employment generation and poverty reduction as key additional objectives.
Finally, the current rapid pace of financial innovation and increasing complexity of cross-border activities pose a substantial challenge for South Asian central banks in ensuring effective monitoring and supervision of the financial sectors in respective countries. This underscores the need to strengthen the framework for cooperation among the central banks and regulatory institutions, including sharing of experiences and expertise to fill critical gaps in information flows and facilitate crisis management. Recognizing such needs, financial regulators and central banks of the South Asian Association for Regional Cooperation (SAARC) of eight countries (Afghanistan, Bangladesh, Bhutan, India, Nepal, Maldives, Pakistan and Sri Lanka) have formed the SAARCHNANCE Group in 2002 comprising the Governors of the central banks and the Secretaries of the finance ministries. Besides this, the Asian Clearing Union (ACU) set up in 1974 by the initiative of ESCAP for eight countries also plays an important role in settlement of payments of trade among the member countries (Bangladesh, Bhutan., India, Iran, Nepal, Myanmar, Pakistan and Sri Lanka).
Conclusions and policy options: The immediate challenge for the central banks in South Asia is to contain the rapidly rising inflationary pressures. The nature and intensity of inflation across countries also vary. In some countries, inflation is largely home-grown fuelled by excessive aggregate demand gathered through years of accommodative monetary policy. For others, domestic supply shocks and global price hikes played the key role and kindled the flames. In view of the complex nature of inflation dynamics in South Asian countries, the monetary authorities no doubt face a very difficult environment with significant uncertainties surrounding the choice right policies. Moreover, external price shocks that first made themselves felt few years back are yet to fully pass on to domestic consumers and producers in many countries of the region. Thus even if international commodity prices ease at present, the pass-through of higher prices will add on to inflation pressures at least in the near term.
In the present circumstances, direct measures could also play important roles in reducing inflationary pressures in South Asia so that it may not be desirable to leave the burden of keeping inflation at low levels only on demand management policies.
With rising food prices, one useful way to dampen the price effects of food supply shocks is to maintain adequate strategic buffer stock of food that could be released when needed through different food transfer programmes targeted to the poor and food insecure households. Keeping in view the financial burden of subsidies in the context of limited fiscal space of the governments, targeted safety nets programmes, feeding programmes for school children, food-for-work programmes, open market sales, and guaranteed employment programme for the poor and disadvantaged households especially during the lean seasons could be used in the short run to enhance food entitlements and stabilize prices. Along with mitigating the inflationary impact on the poor through generating short-term employment opportunities and providing access to transfer incomes in the rural areas, it is important to ensure food to the poor at subsidized prices especially in the urban areas as they do not have any surplus food at home.
At the same time, providing agriculture credit, making input supplies more reliable, and relaxing trade policies may bring consumer gain in the short run while providing timely market information would assist the producers to take informed decisions. The thrust of the macroeconomic policies should be on increasing domestic production and stabilizing supply since the demand of food by the poor is quite inelastic which makes them vulnerable due to supply variability of food.
In the medium term, responses such as improving institutional capacities and governance structures including investments in agricultural research, technology, and extension services and in improving trade, marketing, and post-harvest facilities are the feasible ways of sustaining positive near term outcomes. Similarly, investment in education and health in rural areas, infrastructure such as irrigation and rural roads can bring out productivity gains and alleviate the trend of higher prices and food prices in general. At the same time, efforts to stay on inclusive growth path would facilitate policies for addressing the challenges of rising and high food prices facing the poor.
Obviously, efforts to keep inflation within tolerable limits involve a long term battle with support of prudent policies. For this, it is important for South Asian countries to ensure highest sustainable growth in domestic output consistent with price stability that requires continuous pursuit of supportive macroeconomic policies; growth in private sector-led investment; measures to reduce power, transport, and other infrastructure constraints; and speedy implementation of structural, institutional, and financial sector reforms.
In order to restore the South Asian economies to higher growth path over the medium to long term, significant efficiency and productivity improvements are required to meet the challenge of limited resources, particularly land (and thus food) and fuel. Moreover, effective implementation of country-specific reform agendas-- that focus on consumers responding to market-oriented price signals on the one hand and on producers improving efficiency and productivity on the other--are imperative to strengthen competitiveness, foster growth, and generate productive and decent job opportunities. Obviously, moderating inflation and raising economic growth in South Asia require painful tradeoffs. However, this should not be taken as an excuse for delays in implementing much-needed corrective policy measures to the detriment of both short-and medium-term outlooks. In particular, coordinated monetary and fiscal measures are needed to contain inflation and achieve higher growth for which it would also be desirable to firmly anchor inflation expectations pre-emptively and decisively.
The writer is Governor of Bangladesh Bank, the central bank of the country
IN the backdrop of rapid globalization and accelerating economic growth, it is important to identify various channels through which global integration can affect inflation and monetary policies in South Asian countries. Certainly, greater integration of any economy means that inflation in the domestic economy is more open to external pressures coming from outside the country. The general economic argument is that globalization helps to reduce inflation everywhere.
However, in the case of South Asian countries, this proposition may not be entirely tenable. The reasons lie in many factors including high import dependence, increased global pressure of excess demand, and weak productivity growth in the domestic economy, and persistence of significant structural and institutional rigidities. Moreover, the causalities have country-specific characteristics including wide variation in relative roles of demand and supply side factors across countries and over different periods in the same country. In addition, widening internationalization of inflation in South Asia also means diminished role of central banks in managing domestic inflation.
In the context of a positive association between excess growth in money supply and inflation, it is held that money supply growth affects growth in real GDP in the first round while the second round effect is felt by inflation. Therefore, to avoid inflationary pressures in the economy, formulation of monetary policy needs to be based on a comprehensive consideration of the developments in the real and financial sectors of the economy. Since high growth in money supply can trigger inflationary pressures, it would be important for the central banks to remain cautious about the growth of money supply and its implications on the economy
A significant issue in adopting appropriate monetary strategy is the relevance of inflation targeting (IT) regime in South Asian countries. Since the 1990s, IT has emerged as the dominant monetary policy paradigm in several countries--developed and developing ones alike. Many other countries often pursue 'inflation caps' especially in the context of IMF programmes which can be viewed as a first move toward IT. It is often maintained that IT institutionalizes good monetary policy, increases the transparency and accountability of the central bank, and provides guideline for other government policies. It also helps to shape private sector expectations that reduce the uncertainty and cost associated with adjustment to low inflation regimes. The gains of IT regime are, however, not well established and there are views that IT may entail several economic costs such as cost of targeting low inflation, cost of high real interest rate, cost of conflict between IT and balance of payments, and cost of conflict between IT and financial stability. In South Asian countries, anti-inflation strategy based on IT appears difficult to implement under the present circumstances especially in view of the problems in fulfilling the institutional requirements for IT, existence of balance of payments vulnerability, and prevalence of shallow financial markets that restrict the sensitivity of interest rate changes in achieving macroeconomic outcomes. Moreover, policies of pursuing low inflation alone may not be desirable in South Asian countries as this might lock the economies in low employment equilibrium with consequent adverse impact on poverty.
One of the important functions of the central banks in South Asia is to regulate and supervise the financial system with the views to safeguard the soundness of the financial system and absorb possible adverse shocks that could be detrimental to economic growth, and improve the efficiency of the financial system and deepen financial intermediation with a view to channelling an increasingly greater volume of financial resources to the productive sectors of the economy. Thus vigorous pursuit of developmental and promotional roles through targeted interventions in the financial sector is important for central banks in South Asia. This, however, need not lead to any compromise on the core objectives of price and financial stability. In order to play desired roles in national development, it is time for the central banks in South Asia to come out of the 'black box' of conventional targets and include employment generation and poverty reduction as key additional objectives.
Finally, the current rapid pace of financial innovation and increasing complexity of cross-border activities pose a substantial challenge for South Asian central banks in ensuring effective monitoring and supervision of the financial sectors in respective countries. This underscores the need to strengthen the framework for cooperation among the central banks and regulatory institutions, including sharing of experiences and expertise to fill critical gaps in information flows and facilitate crisis management. Recognizing such needs, financial regulators and central banks of the South Asian Association for Regional Cooperation (SAARC) of eight countries (Afghanistan, Bangladesh, Bhutan, India, Nepal, Maldives, Pakistan and Sri Lanka) have formed the SAARCHNANCE Group in 2002 comprising the Governors of the central banks and the Secretaries of the finance ministries. Besides this, the Asian Clearing Union (ACU) set up in 1974 by the initiative of ESCAP for eight countries also plays an important role in settlement of payments of trade among the member countries (Bangladesh, Bhutan., India, Iran, Nepal, Myanmar, Pakistan and Sri Lanka).
Conclusions and policy options: The immediate challenge for the central banks in South Asia is to contain the rapidly rising inflationary pressures. The nature and intensity of inflation across countries also vary. In some countries, inflation is largely home-grown fuelled by excessive aggregate demand gathered through years of accommodative monetary policy. For others, domestic supply shocks and global price hikes played the key role and kindled the flames. In view of the complex nature of inflation dynamics in South Asian countries, the monetary authorities no doubt face a very difficult environment with significant uncertainties surrounding the choice right policies. Moreover, external price shocks that first made themselves felt few years back are yet to fully pass on to domestic consumers and producers in many countries of the region. Thus even if international commodity prices ease at present, the pass-through of higher prices will add on to inflation pressures at least in the near term.
In the present circumstances, direct measures could also play important roles in reducing inflationary pressures in South Asia so that it may not be desirable to leave the burden of keeping inflation at low levels only on demand management policies.
With rising food prices, one useful way to dampen the price effects of food supply shocks is to maintain adequate strategic buffer stock of food that could be released when needed through different food transfer programmes targeted to the poor and food insecure households. Keeping in view the financial burden of subsidies in the context of limited fiscal space of the governments, targeted safety nets programmes, feeding programmes for school children, food-for-work programmes, open market sales, and guaranteed employment programme for the poor and disadvantaged households especially during the lean seasons could be used in the short run to enhance food entitlements and stabilize prices. Along with mitigating the inflationary impact on the poor through generating short-term employment opportunities and providing access to transfer incomes in the rural areas, it is important to ensure food to the poor at subsidized prices especially in the urban areas as they do not have any surplus food at home.
At the same time, providing agriculture credit, making input supplies more reliable, and relaxing trade policies may bring consumer gain in the short run while providing timely market information would assist the producers to take informed decisions. The thrust of the macroeconomic policies should be on increasing domestic production and stabilizing supply since the demand of food by the poor is quite inelastic which makes them vulnerable due to supply variability of food.
In the medium term, responses such as improving institutional capacities and governance structures including investments in agricultural research, technology, and extension services and in improving trade, marketing, and post-harvest facilities are the feasible ways of sustaining positive near term outcomes. Similarly, investment in education and health in rural areas, infrastructure such as irrigation and rural roads can bring out productivity gains and alleviate the trend of higher prices and food prices in general. At the same time, efforts to stay on inclusive growth path would facilitate policies for addressing the challenges of rising and high food prices facing the poor.
Obviously, efforts to keep inflation within tolerable limits involve a long term battle with support of prudent policies. For this, it is important for South Asian countries to ensure highest sustainable growth in domestic output consistent with price stability that requires continuous pursuit of supportive macroeconomic policies; growth in private sector-led investment; measures to reduce power, transport, and other infrastructure constraints; and speedy implementation of structural, institutional, and financial sector reforms.
In order to restore the South Asian economies to higher growth path over the medium to long term, significant efficiency and productivity improvements are required to meet the challenge of limited resources, particularly land (and thus food) and fuel. Moreover, effective implementation of country-specific reform agendas-- that focus on consumers responding to market-oriented price signals on the one hand and on producers improving efficiency and productivity on the other--are imperative to strengthen competitiveness, foster growth, and generate productive and decent job opportunities. Obviously, moderating inflation and raising economic growth in South Asia require painful tradeoffs. However, this should not be taken as an excuse for delays in implementing much-needed corrective policy measures to the detriment of both short-and medium-term outlooks. In particular, coordinated monetary and fiscal measures are needed to contain inflation and achieve higher growth for which it would also be desirable to firmly anchor inflation expectations pre-emptively and decisively.
The writer is Governor of Bangladesh Bank, the central bank of the country