By Sameer Sharma
Central banks globally have been moving towards some form of inflation targeting, be it fixed or flexible, while another select grouping have maintained other frameworks such as exchange rate targeting or monetary targeting. Central banks which follow monetary targeting have become increasingly rare given the crudeness of such an approach, as behavioural economics has gained traction and as capital markets have developed.
Exchange rate targeting for its part is a highly complex task requiring significant ammunition in the form of large foreign exchange reserves. Exchange rate targeting, if well implemented, allows a country to import the inflation rate of the pegged target country – the US dollar, the Euro or a trade weighted nominal effective exchange rate serve as typical anchors – but it comes at the cost of a country losing monetary independence and flexibility, especially when economic fortunes diverge from that of the target country or countries. Maintaining a peg also requires significant levels of international reserves, which is no easy task if your country runs structural trade deficits or is highly sensitive to external shocks. Many local private sector funded lobby groups have promoted some form of exchange rate targeting in the past, but what they were really seeking was frequent currency adjustments lower in order to boost their so-called competitiveness which is as rare as the dodo itself.
Inflation targeting ironically first started out in a small and open economy like New Zealand and has gained success across the world given the wide acceptance of behavioural economics.
While central banks cannot obviously control commodity prices and what is known as first round effects in general, there is significant evidence across the world, given the success of inflation targeting, that they can indeed anchor inflation expectations and bring about price stability by containing second round effects over the medium term. Through the interest rate channel, a well-engineered flexible inflation targeting regime can bring about price stability while also offering moderate flexibility when it comes to pursuing other objectives which are secondary such as foreign exchange interventions aimed at smoothing volatility and the usual growth objective. This is all done by influencing behaviours and expectations which impact aggregate demand. That the shock is initially supply rather than demand driven is actually secondary because central banks are focusing on the future and not the present. It is about the market believing that you will achieve your target in the end.
Five pillars of inflation targeting
In order for a central bank to achieve success when it comes to flexible inflation targeting, it must be able to have the right architecture in place first. The required architecture can be summed up as follows.
First, the central bank must have a clearly defined fixed or flexible inflation target that is ideally calculated based on a year-on-year metric. Ideally, the flexible inflation target band must be symmetric. The consumer price index basket must also be continuously updated especially after the recent pandemic which has obviously brought about behavioural changes and intrinsic biases within the index. Not only should the flexible inflation target band be symmetric, but one should not be overly flexible.
Basically, typical inflation target bands should range between 100 basis points and 150 basis points around the long-term desired target. If it is too high, you simply lose credibility. It is very hard for a central bank to achieve and maintain price stability at a fixed target, and overshoots are common. When your band is so wide, then rather than even achieving a 5% upper bound target for example, you may end up only achieving 5.5% to 6%. Expectations and credibility matters.
Second, the central bank must be independent whilst remaining accountable. Central banks are typically accountable to the Parliament in modern democracies. Ghana, for example, adopted flexible inflation targeting but has had limited success in bringing down inflation to the upper bound of the target over time. The main culprit is a lack of credibility that was caused by significant fiscal dominance over the central bank. This essentially led the Central Bank of Ghana to continuously overshoot its target band.
Third, ideally, the interbank repo market, which is the key ingredient for the proper functioning of any secondary bond market, needs to be mature. The secondary bond market itself is a critical component of the transmission mechanism of monetary policy from short-term money markets to long-term yields. The link between the secondary bond market and credit spreads needs to be very strong. There is an obvious linkage between the secondary bond market, particularly at a longer end of the yield curve, and lending rates. That’s how it should work.
The link between the secondary bond market and credit spreads needs to be very strong.
Fourth, while it is true that a central bank cannot default on domestic liabilities, it is again an issue of credibility of achieving its primary mandate that matters. If the central bank finds itself depending heavily on the depreciation of the currency to show positive equity on a monthly basis, which goes counter to its inflation mandate (currency depreciation does not tend to go well with things like inflation after all), then there is obviously a problem. Conducting monetary operations at the short end of the yield curve can be very expensive and it would make zero sense for a central bank with negative equity to be essentially printing money to fund its liabilities. If the central bank has a long history of achieving its inflation target and if the level of negative equity is a result of a strong currency because the economy is doing very well, one can understand and rationalize the level of economic capital. When that is not the case, however, such arguments that economic capital does not really matter become weak. This is why it is important for central banks, especially those in emerging and frontier markets, to hold a decent level of economic capital relative to their total assets. The adequate amount of economic capital should be linked to the risks the central bank faces. One risk that may be discounted would be that of the domestic currency’s appreciation, especially if this is the result of a buoyant economy.
Fifth, it is important for the central bank to have access to high frequency economic data, and it is also critically important for the central bank to have economists who can model and forecast properly. It is also important for the central bank to be blessed with a leadership and a monetary policy committee that is qualified for something that is very technical. If you do not have the right people at the right place, you will not have the credibility to succeed. It is important for the central bank to clearly communicate the framework that it will use to determine the appropriate level of interest rates that it will set to achieve its target over an 18-to-24-month period. After all, it takes time for monetary policy to start to work even when the architecture is well set up.
Distortions in the money market
It is one thing to announce an inflation target framework and remove excess liquidity by conducting more open market operations, but it is something else to be successful at achieving the target. For a central bank to achieve its target, it needs to be able to have the right architecture in place. In all five counts, the Bank of Mauritius has obvious limitations.
Firstly, when it comes to the target itself, the Bank of Mauritius has adopted the headline inflation metric which makes sense for pension funds when they calculate how much they would be increasing pension payments every year and for wage setting, but it makes zero sense as a target. No other central bank targets some smooth inflation rate, i.e. some average CPI level divided by some other average CPI level. The inflation band is also not symmetric and showcases obvious biases of the objective function towards growth. The Bank of Mauritius aims to achieve a 3% headline inflation level over the long term, but its 200 basis point inflation band of 3 to 5% will likely lead it to overshoot this long-term target more often than not.
Secondly, fiscal dominance remains significant over the Bank of Mauritius. From the nominations of the leadership to the nomination of the Monetary Policy Committee to the nomination of the Board of Directors of the Bank of Mauritius itself, it is obvious that fiscal dominance is strong and that relevant skill sets are not plentiful. That is not to say that the members of the MPC and the Board are not accomplished individuals, but it is something else to argue that they are experts in this field. For example, we seem to have more barristers who lead the central bank than we actually have economists with advanced quantitative degrees and economics.
The government currently depends heavily on the inflation tax which allows it to artificially boost both nominal GDP and tax revenues. Rising interest rates also means rising debt servicing costs to the government. The nomination of a Governor is only for a rolling 3-year period which is lower than the 5-year election cycle. The Bank of Mauritius fully owns the Mauritius Investment Corporation (MIC) which essentially acts as the investment arm or fiscal agent of government. We saw that with Air Mauritius.
Fiscal dominance remains significant over the Bank of Mauritius.
Mauritius has never really been able to develop its interbank repo market and its central bank itself has never been able to conduct effective reverse repo and repo transactions with banks. The current 7-day Bank of Mauritius Bill is essentially a poor man’s way of getting around the problem. The interbank lending rate is supposed to closely track the 7-day Bill. Ideally, the interbank rate should be higher than the 7-day Bill which should be quasi risk free. The spread between the overnight and the one-week interbank rate to the 7-day Bank of Mauritius Bill is quite low given the actual risks, but at least it is positive.
At the short end of the yield curve up to the one-year bill however, we notice many instances where short-term treasuries are trading at a discount or at a bare bones premium to the 7-day Bill yield. In a well-functioning secondary bond market, it is definitely possible for yield curves to be flat or to be inverted, but in the case of Mauritius, we are noticing that the combination of constrained short-term government bill supply when coupled with some interesting bidding behaviour by at least one bank is distorting the term premium. With more than 102 outstanding issues of small sizes, the government bond market remains highly fragmented given the accounting approach to debt management versus how it should be done with large issue sizes at key benchmark maturities.
When this is coupled with the buy and hold behaviour of local institutional investors, this can have a significant impact on bond pricing. It is hard to conclude that the recent flattening of the Mauritius yield curve is driven by a much weaker economic outlook or by the structure and limitations of the current secondary bond market. What is clear though is that the secondary bond market is supposed to act as a pipeline between shorter monetary policy instrument yields and the lending rate linked to longer term bonds. We have also seen that corporate credit spreads in the corporate bond market remain extremely depressed.
There are various factors that can explain this, but the point here is that given all these complexities, the transmission mechanism from the key policy rate to output and inflation will remain weak. You need to fix your pipes and if you don’t fix them, you should not expect the same level of a success as a central bank that has bothered to fix them before implementing something as complex as flexible inflation targeting. It is not that flexible inflation target is bad, but it is just that one counts as an exam without doing any homework and studying for it.
Thirdly, another distortion in the short-term money market this time is the difference between the short-term savings rate that banks offer to retail investors and some high net worth individuals and the 7-day Bank of Mauritius Bill rate. Right now, a commercial bank essentially gets money from retail customers and pays them 3% It then places this money risk free at 4.5% and roll it every 7 days. Liquidity risk management considerations aside, this is a distortion the Bank of Mauritius needs to fix especially when the rupee is again depreciating.
The transmission mechanism from the key policy rate to output and inflation will remain weak.
For example, the central bank would essentially open up the 7-day paper auction to money market funds that would be more readily accessible to retail investors locally. They would at least have an alternative to place their money in local money market fund rather than try to go after US dollar short term bills which still trade at a significant premium. Access to such short-term paper by institutionally managed money market funds would boost their liquidity profiles and create some serious competition for banks which would then be forced to raise their savings deposit rates. Moral suasion plays a big role if the regulator bothers to use it as well.
The Bank of Mauritius has an asset liability problem
Fourthly, the biggest reason why the Bank of Mauritius has yet to go into negative equity is the depreciation of the rupee that we have seen since the beginning of the year – assuming that we ignore any marked-to-market losses that the MIC is making given rising interest rates (its convertible bonds cannot trade like equity irrespective of the price of the stock relative to strike simply because they are European and because the issuer can call back the bond at any time which destroys the option value). It is very obvious to any technical person that understands central bank balance sheets that the Bank of Mauritius has an asset liability problem wherein it is unable to generate an adequate level of seigniorage income.
It also appears that the Bank of Mauritius has an obvious liquidity problem which may be hopefully temporary in nature. If one takes gross international reserves and strips out the amount of international reserves held to maturity, gold holdings, money belonging to commercial banks held at the central bank, foreign borrowings of the central bank and the loss-making investments it has obviously made in its fair value through profit and loss book (just have a look at the 12-month evolution from the monthly financial statements), the Bank of Mauritius cannot obviously sustain continued large interventions especially when the country has a structural current account deficit problem and when the currency is obviously overvalued anyway. It may take some time for global markets to recover, allowing the central bank to then make greater use of its fair value through profit and loss book by disposing of assets and intervening in their market.
Putting interventions aside, one could argue that the volatility of the currency is low and the Bank of Mauritius under the new framework should be focusing on interest rates rather than on continued interventions. I would tend to agree but the problem is that the returns that it is making on its assets (we should not hold a lot of hope with the MIC) is not sufficient to help it match its liabilities.
The Bank of Mauritius needs to adopt a much more modern strategic asset allocation framework, and it needs to be very dynamic in the way it manages risks across various market regimes. It does not appear that it does that, but that is what it needs to do. Unless it evolves the way in which it manages money, it will never be able to properly match its liabilities and rebuild capital buffers. It is also obvious that as a frontier market central bank, it needs a risk-based buffer when it comes to economic capital. The Bank of Mauritius today has more risks on its balance sheet that it ever did in the past given the MIC, and when it comes to international reserves, global market volatility is higher today than it was before the pandemic hit us.
Prior to the crisis and prior to the 18-billion rupee transfer in December 2019, the Bank of Mauritius had an economic capital to total assets ratio of 13%. I do not wish to comment on whether this level was adequate or not, but what is clear is that with more risks on its balance sheet, it currently runs only around 1 to 2% depending on the direction of the rupee. This is obviously very low and it requires significant recapitalization as has been highly recommended by the International Monetary Fund.
The IMF has actually been clear about the fact that not recapitalizing the Bank of Mauritius as soon as possible would significantly impact its credibility and the success of the new monetary policy framework. The government has no plans to return the Special Funds money that came from the Bank of Mauritius printing press, and the opposition too seems to be very confused about money printing and inflation and what is the source of funds of the government special funds. Some in the opposition think that Special Funds money, which is actually printed money, is good for the economy and is bullish.
Fifthly, the Bank of Mauritius was very wrong in 2022 when it said inflation was transitory. Today the 5-year ahead inflation expectations in Mauritius are well above 6% and core inflation, which strips out a lot of the imports that we consume, stands at a whopping 7.4%. Year-on-year inflation is above 11%. There is obviously something terribly wrong in the way in which the Bank of Mauritius forecasts and analyses inflation dynamics.
The key policy rate needs to be above 6%.
It should also be mentioned here that the long-term potential growth rate of Mauritius is not 5% and nor is it 4%. It is now closer to 3%. We have already achieved potential output and now we are beginning to notice that the economy is overheating. When coupled with the loose anchoring of inflation expectations and given the 5% upper bound relative to the current level of inflation, this requires higher interest rates.
Applying the adjusted Taylor rule equation to Mauritius, which is part of the new framework anyway, the key policy rate needs to be above 6% given the current state of the output gap and the current level of inflation relative to the upper bound of the target itself. There is no doubt that some within the Bank of Mauritius understand this as well because it would not be economically sound to assume that one could achieve the inflation target with 4.5% or 5.25% as the key rate. The question obviously is: will the central bank even raise interest rates above 6% in order to achieve the upper bound of its inflation target which is at 5%?
Living up to the credibility challenge
Over the last three years, we have drugged this economy with cheap money, and private sector debt has increased. The government also has a lot of debt because it was busy bailing out everybody under the sun without raising taxes. Private sector debt when added to public sector debt and to the present value of unfunded basic retirement pension liabilities would easily top 1 trillion rupees.
The key risk factor would ironically be for the Bank of Mauritius to increase interest rates in a much more meaningful matter in order to contain inflation expectations and achieve its upper bound 5% target which in itself is high over two years. However, doing so in a country that lacks high frequency economic data could lead to significant financial stability risks that we do not like to talk about too much. That puts the central bank in an interesting conundrum of “damned if you do and damned if you don’t”.
Right now, it is the poor that are paying the inflation tax, but if you increase rates too much, then other problems could crop up. This creates interesting credibility challenges for the central bank which has kept interest rates at 4.5% when inflation is still above 11%. The new objective of the Bank of Mauritius is no longer to match what the US Federal Reserve does – which anyway it is not even doing properly given what people get on their savings deposits and given yields on short-term treasuries in Mauritius – but it is indeed to achieve its inflation target. This is not 2022 anymore.
Inflation in Mauritius will only peak by March 2023 and will slowly begin its decline and may end up at more than 6% by the end of the year. This is a very high level of inflation rate. The government won’t mind it because it has an unsustainable fiscal problem with pensions and debt. The private sector won’t mind it because the inflation rate allows it to reduce the real value of debt over time. The currency depreciation is currently boosting corporate profits as well.
It is unclear whether the Bank of Mauritius with its current set-up with a monetary policy committee that has only one or two highly qualified economists (who understand monetary policy making well) will be able to achieve its primary objective which is to bring inflation down to between 2% and 5% over the next 24 months and keep it there. More importantly for Mauritius to remain competitive, it is important to bring inflation down to 3% over the next two years, but we are very far away from that right now.