CBI Empowerment

Stagflation is the most undesirable state for a country to find itself in and is the most difficult position to get itself out of as economic policies designed to end recession may exacerbate inflation, and vice versa. Ending stagflation requires taking a hard look at the market in question in order to reach a clear understanding on the depth and scope.
Statistics on the prices and inflation are currently updated on a monthly basis with 2011 serving as the base year that adds to the desired accuracy. However, there are two issues regarding the statistics on the production developments. Firstly, figures are not published daily and their delayed distribution among policy makers poses a challenge. Secondly, updating the base year affects the depth and scope of recession. For instance, decline in non-oil production was 3.8% with 1997 as the base year; having updated the base year to 2004, the same figure for the same year stood at 0.9%. Another figure may be achieved if the base year is updated to 2011 (which is a more suitable base year). Undoubtedly, no sound judgment can be made on the depth of recession relying on such statistics. Obtaining a crystal-clear picture on the depth of recession for deciding on the policy variables is as vital as the precise result of medical examination which is essential to decide on the dose of prescribed medicine.
Having carefully measured the depth and scope of stagflation, it is most important to find out the root cause, otherwise we may just be curing the symptoms. The problem will still persist. Comparing non-oil and oil-plus production figures indicate that the major decline in production in 2012 relates to direct and indirect impact of fall in oil production (6.8% to 0.9%, base year: 2004) arising from sanctions. Thus, finding solutions to remove unfair economic sanctions, which is the government's priority at the moment, is the key to end stagflation. Nevertheless, the result of efforts depends on non-economic factors which are beyond the policymakers' control.
Given the above, it seems that inflation rate is a key variable that needs to be addressed by the policymaker in the short run as its high levels discourages production and is the main reason behind inefficient and improper allocation of resources in economy. Thus, restoring inflation rate to its long-term level (which is 15% in the Iranian economy) would push up investment and production without any negative impact on the economy. Fortunately, the new administration has rightly targeted this to get through economic difficulties.
The main challenge in the course of curbing inflation is to set the interest rates and establish the mechanism through which they are decided. Currently, the monetary policymakers have focused on controlling liquidity growth and no specific position has been taken regarding the interest rates. Apparently, relevant authorities believe that the interest rates should not decrease for the time being and the best way to set them is through moral suasion. (Lately, the public and private banks agreed on a unified interest rate while taking into account the concerns expressed by the policymakers. Therefore, it seems that currently the policymaker is setting the rate through moral suasion).
Economically speaking, at this rate, the position adopted by the policymakers to monitor liquidity growth and not to reduce interest rates seems logical. However, it may be possible to make monetary policies more effective by applying some changes in the interest rate setting process. This would help reduce the adverse impact of contractionary policies on production while curbing inflation.
The following proposal seeks to empower Central Bank of Iran from a policy-making perspective. The proposed solution encourages CBI to set the interest rates at macro level instead of retail level (based on the gap between production and inflation or the gap between the real and targeted inflation) through instructions or moral suasion. Retail interest rate setting can be devolved to the market. The proposal assumes that CBI enjoys enough independence in the process. (Although according to the regulations, CBI is not an independent body; the current approach by the government implies independence for this authority.)
As mentioned earlier, CBI is using moral suasion to set the interest rate within the current monetary policy framework. The argument against this approach is that it can disturb the balance in the market. In light of existing rates, it seems that the demand for financial resources surpasses the supply. It has been frequently announced that the banks lack required resources for financing industries. The rising demand has resulted in credit rationing in economy. In other words, not all the applicants for banking facilities can be covered. Regulating the supply-demand cycle in money market requires long-term planning by a certain body. However, the following corrective proposal may help achieve the same in the short run:
CBI should focus on setting fully operational interest rates at macro level by moral suasion. In other words, CBI sets the interest rates on short-term deposits (from one night or one month to any period below one year) based on its objectives. It grants facilities to the qualified banks or invites them to invest their deposits in its accounts. Within this framework, CBI has nothing do with the rates decided in inter-bank markets or retail rates set by banks. This is how the rate set by the policy maker is operationally enforced.
Realizing the said objective requires Money & Credit Council to set and announce the short-term interest rate to the banks while monitoring the monthly prices and production statistics closely and taking CBI's short-term forecasts for macro variables into account. The rates could be then adjusted based on short-term economic developments (as discussed and closely followed in the regular meetings of the Council). In the beginning and in the absence of a base rate, the Council may need to adjust the rates more often and at shorter intervals. The market should be shaped in a way that all economic actors follow the rate set by the Council while making decisions. The policy maker should always bear in mind that, as a rule, the real rate should not be negative.
In addition, CBI should define a framework for granting facilities to the bank based on their credit ranking. Undoubtedly, the banks, in turn, should provide required collateral to utilize CBI resources. Those banks with lower credit ranking would face more difficulties in accessing CBI facilities and therefore, have to resort to inter-bank market with higher interest rate to meet their deficit.
The framework, therefore, is summarized under the following principles:
1- Since retail interest rates (banking facilities and deposit rates) are not set by instructions or through moral suasion, the rates in inter-bank market and at retail level are decided freely depending on the market situation. This helps the producers and consumers meet their financial needs with the existing rates and create balance within the market.
2- Base interest rates are regularly adjusted depending on the economic situation. (The difference between retail and base interest rates would depend on banking system efficiency and the extent to which the applicants for facilities are ready to take risks. This can be easily managed).
3- Elimination of instructed rates would mitigate rent and corruption in the banking system.
In conclusion, it should be noted that a new arrangement aimed at strengthening CBI to implement more effective monetary policies can simultaneously curb inflation, boost growth and end recession through better allocation of financial resources and systematic elimination of rent.