Monetary Policy and Inflation
Steven Barnett
(May 2010)
Summary and Outline
I. Inflation poses a major risk
– Too high and rising
– Broad-based
• Not just meat prices
• Also excess demand
II. Monetary tightening must continue
– Control inflation expectations
– Monetary conditions loosened considerably
III. Tightening will reduce overheating
I. Inflation has risen…
40
40
CPI: Annual versus Current Momentum in Inflation
30
30
20
20
10
10
0
0
Year on year change
Current (SA trend component)
-10
-10
2003
2004
2005
2006
2007
2008
2009
…increase is not just food
60
60
Food and Non-food Inflation
50
50
40
40
30
30
20
20
10
10
0
0
Food
Non-food
-10
-10
2003
2004
2005
2006
2007
2008
2009
Inflation is broad based
Overall CPI
Current
Weight
Year on year
(in %)
(In percent)
Inflation, April 2010
Contribution to inflation
(Percentage
Share of
points)
inflation
SAAR 1/
(In percent)
100.0
8.4
8.4
100.0
20.3
77.9
9.0
7.2
86.0
18.5
Food
41.1
9.9
4.7
55.7
19.0
Non-food
36.8
7.8
2.6
30.4
10.2
Administered
22.1
5.8
1.2
13.7
16.9
Market based
Sources: NSO; and staff calculations
1/ Seasonally adjusted quarterly inflation at an annualized rate.
Optimistic Projection: Inflation hits double-digits.
Assumes (i) no spending increase; and (ii) further monetary tightening
25
25
Inflation Projection
20
20
15
15
10
10
5
5
0
0
-5
2009M01
-5
2009M07
2010M01
2010M07
II. Tightening should continue
• Inflation expectations are rising
– Official statements & interviews
• Inflation going to 20+ percent
– Impact of fiscal policy (wage increase)
• Expected inflation critical for monetary policy
– Self-fulfilling
– Could become very costly
• Spiral out of control
• Rapid dollarization is possible
• Disinflation is painful
We model inflation expectations as backward looking. Actual inflation
expectations, however, are significantly higher…
35
35
Expected Annual Inflation
30
30
25
25
20
20
15
15
10
10
5
5
0
0
Actual, current
Expected, 1 year ahead
-5
-5
2005
2006
2007
2008
2009
…so the ‘true’ real interest rate is much lower than this chart suggests.
Meaning monetary policy is even looser than appears in the chart.
30
30
Real Interest Rates
Central bank bill
Deposit
Lending
25
25
20
20
15
15
10
10
5
5
0
0
-5
-5
-10
-10
2005
2006
2007
2008
2009
Lending rate is (i) low in real terms; (ii) low relative to onshore US$ rates
(given inflation differentials); and (iii) high onshore US$ rates highlight role
of structural problems in the banking system…
35
35
Lending Interest Rates
30
30
25
25
20
20
15
15
10
10
5
Togrog
US$ (Mongolian banks)
Real Togrog
5
0
0
2005
2006
2007
2008
2009
…as do high onshore US$ deposit rates. Decline in real deposit rates is
dangerous—risk of dollarization and could trigger bank or currency run.
16
16
Deposit Interest Rates
12
12
8
8
4
4
0
0
-4
Togrog
US$ (Mongolian banks)
Real Togrog
-4
-8
-8
2005
2006
2007
2008
2009
How to Tighten Monetary Policy
• Further hike in policy interest rate
– Fight inflation by cooling economy
– Promote financial stability
– Drain excess liquidity from banks
• Allow currency to appreciate
– Little to no intervention in fx auctions
– Will allow market to drive appreciation
• So it happens naturally
• Central bank should not resist
Output is above potential output  Economy
is overheating. Demand is driving inflation!
4
4
Mongolia: Output Gap
3
3
2
2
1
1
0
0
-1
-1
-2
-2
-3
-3
-4
-4
2003
2004
2005
2006
2007
2008
2009
Overheating has started
• Economy is starting a major boom
– Export earnings are surging (up 64%)
– Private demand also surging
• Consumer good imports up 64%
• Investment imports up 38% (Oyu Tolgoi will drive up)
• Manufacturing production up 20%
• Economy is already overheating
– Fiscal plans would fuel massive overheating
– Monetary policy would need to subtract more
Fiscal or monetary stimulus will hurt,
not help, the economy
• Policy loosening worsens overheating
• Domestic supply cannot respond
– Domestic firms raise prices (e.g., inflation)
– Fiscal stimulus benefits foreign firms
• Imports surge to meet increase in demand
• Real currency appreciation makes imports cheaper
– Workers demand higher wages (wage-price spiral)
• Long-run damage is even greater
Monetary Tightening Works By:
• Squeezing private sector
– Higher interest rates lower investment
– Reduces overheating and thus inflation pressure
• Nominal appreciation of the currency
– Real appreciation will happen one way or another
– Nominal is much less costly than inflation
• Helps switch demand to imports
– Reduces overheating by hurting domestic firms
• Export firms shrink because they are less competitive
• Same with import competing firms
Awful Policy Mix
• Fiscal Loosening + Monetary Tightening
– Hurts domestic private sector
• Government grows at the expense of private business
– Helps foreign firms
– High costs in short and long run
• Monetary policy can also do so much
– Fiscal plans cannot be offset with monetary policy
– Inflation will skyrocket
– Repeat of the boom-bust cycle