When Finn Kydland and Edward Prescott, who won the Nobel Prize for Economics in 2004, introduced the concept of “time inconsistency problem” into the macroeconomic jargon, they meant that policy makers have a frequent tendency to say one thing now, but do something else later. One may observe a somewhat similar time inconsistency problem in the policy announcements made by the Central Bank (CB) during the last couple of weeks in dealing with the current economic difficulties.
"Time inconsistency" problem
Kydland and Prescott, in their seminal article of 1977, pointed out that governments have a time inconsistency problem – making a decision later that contradicts its own policy announcement made earlier. They showed that it applies to many policy decisions of governments. For example, governments may find it difficult to reduce inflation due to time inconsistency. The reason being, they prefer to allow money supply growth so as to reduce unemployment in the short run ignoring the fact that low or zero inflation is an optimal goal for the long run. Thus, the governments may never take decisions to reduce inflation with a longer time horizon. To deal with this problem, Kydland and Prescott suggested that policy makers must develop a reputation for credibility arising from the long-term benefits of the policy decisions, recognizing that such benefits have the capacity to beat the short-term costs arising from those policies.
Monetary policy decisions
The time inconsistency problem could be noticed in some of the policy decisions taken by the CB in recent times. For example, in its press release on Monetary Policy Review for January 2012, the CB announced that the market developments did not require any adjustment of the then prevailing monetary policy stance, and therefore, the Bank’s policy interest rates would be kept unchanged at the previous levels. i.e. Repurchase rate of 7% and the Reverse Repurchase rate of 8.5%. That press release was issued on January 12, 2012.
Two weeks later, on February 3rd, however, the CB issued its Monetary Policy Review for February 2012 contradicting its own position in the previous press release. It stated “excess liquidity in the domestic market declined from Rs. 124 billion as at end 2010 to the current level of around Rs. 15 to 20 billion and such decline in liquidity in the domestic market led to market interest rate recording an upward movements in recent months. With excess liquidity declining, commercial banks also competitively raised interest rates paid on deposits, with rates on 3-month and 6-month term deposits showing a considerable increase during the past few months”. Accordingly, CB decided to raise the Repurchase rate and Reverse Repurchase rate by 50 basis points to 7.5% and 9%, respectively.
The February press release indicates that market liquidity had declined throughout 2011, and the market responded by upward movements in interest rates. Nevertheless, the CB did not want to admit the liquidity crunch and the consequent pressure on interest rates until February, and it kept the policy interest rates intact till the last moment. The Repurchase rate and the Reverse Repurchase Rate had been kept at 7% and 8.5%, respectively since August 2010 until the recent revisions. Upward movements in market interest rates including the Treasury Bill rates were noted even in the January press release, although the CB did not adjust its policy rates. The February press release gives us the impression that the CB was compelled to adjust its policy interest rates upwards in response to the rising trend in the market interest rates. Ideally, the CB should have been able to guide the market interest rates responding to the market liquidity conditions much earlier, instead of merely following the market interest rates at the last moment.
Creditability in exchange rate management
Even with regard to exchange rate management, the CB was reluctant to accept the reality of dwindling foreign reserves. The CB continued to defend an overvalued rupee for a long time until it realized the far reaching repercussions of depleting reserves from $8 billion to around $6 billion by the end of 2011. In spite of the underlying balance of payments difficulties emerging from the excessive trade deficit, the increased foreign exchange inflows by way of worker remittances and foreign borrowings enabled the CB to maintain high foreign reserves and an appreciated rupee. It led to create the “Dutch disease” effects encouraging imports and discouraging domestic production and exports.
With effect from 10th February 2012, the CB decided to limit its intervention in the foreign exchange market, so as to confine the supply of foreign exchange to the extent needed to settle the bulk of petroleum import bills, and to absorb surplus foreign exchange liquidity. This decision resulted in a depreciation of the currency to around Rs. 120 a dollar. However, in its short press release issued on January 2, 2012, the CB had categorically stated "… there is no truth whatsoever in the news report as set out in a local newspaper of 2nd January, 2012, that Sri Lanka will devalue the rupee".
Again, this is an example of "time inconsistency" problem - this time with regard to exchange rate management.
In fact, it may be noted here that in a flexible exchange rate system, such as the one that has been in operation in Sri Lanka since 1977, the question of "devaluation" does not arise as the exchange rate needs to be allowed to fluctuate freely within wide margins depending on the demand for and supply in the foreign exchange market. The phenomenon of "devaluation" is applicable only to a fixed exchange rate regime, the one that had been in Sri Lanka prior to 1977, in which the government or the CB had to occasionally "devalue" or "revalue" the domestic currency.
Boost for trading and consumption of imported goods
Prior to the recent policy adjustments, the CB had attempted to keep the two crucial rates – interest rate and the exchange rate – at administratively-decided levels, totally ignoring the market movements. The low interest rates and the overvalued exchange rate manifested by those policies had their adverse implications for the economy. The low interest rates encouraged the traders and consumers of imported goods to obtain cheap credit from banks. Meanwhile, the overvalued exchange rate made imports cheaper. Those two factors contributed to a sharp increase in imports of consumer durables and intermediate goods such as motor vehicles, household goods and sophisticated building materials. The domestic market has been flooded with these products. Moreover, there was no shortage of foreign exchange in financing the heavy import demand for such goods, as the CB was ready to supply the required foreign reserves all the time.
That policy framework provided an ideal environment for import traders to thrive in their businesses and for affluent consumers to possess luxury goods. In other words, that policy stance was conducive to foster import trading and consumption of imported goods at the expense of domestic savings, investment and local production. It is a well accepted premise in international finance that a central bank cannot fix both interest rates and exchange rates simultaneously. At low domestic interest rates, for instance, domestic money supply will expand causing an excess demand for dollars. This will tend to weaken the rupee, which means currency depreciation. In contrast to this golden rule based on the interest rate parity and purchasing power parity theorems, the CB attempted to maintain an appreciated rupee whilst keeping the interest rates at low levels. That is what went wrong.
Restoring CB credibility
The current monetary policy adjustments driven towards more flexible exchange and interest rates, though they came much later resulting in widespread socioeconomic pains, will certainly help to restore the lost credibility of the CB. Nowadays, academics as well as policy makers throughout the world show much interest in central bank independence in formulating monetary policy. The underlying theory behind these discussions is the "time inconsistency" model of Kydland and Prescott that we discussed at the outset of this article. Their answer to the problem of persistent inflation was to make central banks more independent, thus leaving them to follow appropriate monetary policy rules that would prevent them from blindly implementing imprudent policies to satisfy politicians for short-term gains. "The only good central bank is one that can say no to politicians" - The Economist magazine, February 10, 1990.
(The writer is an academic, an economist and a former senior Central Bank official. He can be reached at firstname.lastname@example.org).