Fiscal Deficit Financing by BoG undermines inflation targeting regime

In 2007, the Bank of Ghana adopted an inflation targeting (IT) framework, which was underpinned by a flexible exchange rate regime. Inflation targeting is a monetary policy framework where the central bank sets a specific target for the inflation rate and adjusts its monetary policy tools to achieve that target. The primary goal of inflation targeting is to maintain price stability, which is considered a crucial prerequisite for sustainable economic growth and development.

The Bank of Ghana’s inflation target was set at 8% with a symmetric band of 2%, which means that the bank aimed to keep inflation within a range of 6% to 10%. However, as of March 2023, inflation in Ghana is currently at 52.8%, way beyond the bank’s target, which raises the question of why the inflation targeting regime is not working effectively.

Several possible reasons could be attributed to the Bank of Ghana’s inability to achieve its inflation target. These reasons include fiscal dominance, weak institutions, supply-side shocks, limitations in the transmission mechanism of monetary policy, external factors beyond the control of the bank, among others. Understanding these factors is crucial to identifying the appropriate policy responses needed to address the challenges and improve the effectiveness of the inflation targeting regime.

Central Bank of Ghana Financing

The financing of government operations by the central bank, also known as central bank financing of the fiscal deficit or monetary financing, is a significant challenge in achieving price stability and controlling inflation. When the government spends more than it generates in revenue, it may finance the deficit through borrowing from the central bank, which increases the money supply, leading to an increase in aggregate demand and inflationary pressures.

The central bank’s financing of the government in 2020 to 2022 to the tune of over 90 billion cedis, way above the fiscal responsibility requirement, is one single action that has contributed to the high inflation in the country. The central bank’s financing of the fiscal deficit increases the money supply, leading to an increase in aggregate demand, which puts pressure on prices, leading to inflation.

Even though the Bank of Ghana keeps increasing its policy interest rate to control inflation, the impact may be limited if the government continues to finance its operations through borrowing from the central bank. When the central bank increases the policy interest rate, it aims to reduce the money supply and increase the cost of borrowing, which should lead to a reduction in aggregate demand and inflation. However, if the government continues to borrow from the central bank, it increases the money supply, which undermines the effectiveness of monetary policy in controlling inflation.

To address the challenge of high inflation in Ghana, the government needs to adopt fiscal policies that reduce the fiscal deficit, increase revenue generation, and reduce the reliance on borrowing from the central bank. Additionally, the government needs to implement structural reforms that promote economic diversification, increase productivity, and reduce supply-side constraints that drive inflation.

Furthermore, the Bank of Ghana needs to implement monetary policies that are consistent with achieving its inflation target, including increasing the policy interest rate, managing liquidity in the financial system, and enhancing the effectiveness of the transmission mechanism of monetary policy.

Fiscal Indiscipline

Fiscal indiscipline is another reason why the Bank’s inflation targeting regime is not working. If the government spends beyond its means, as we have witnessed from the past few years, it creates excess demand for goods and services, which could lead to high inflation.

The Bank of Ghana may not have the necessary tools to control government spending, and this may limit its ability to achieve its inflation target. Another reason why the Bank of Ghana’s inflation targeting regime may not be working effectively is due to fiscal dominance.

Fiscal dominance occurs when the fiscal policy of a government undermines the effectiveness of monetary policy. This is what Ghanaians have witnessed under the current government. This happens when the government engages in excessive spending, borrows excessively, or pursues other policies that create macroeconomic imbalances.

In Ghana, fiscal dominance could be a significant factor behind the current high inflation rate. The government’s expenditure has been increasing rapidly, partly due to free senior high school and other flagship government policies which have been ineffectively implemented.

The government has had to spend more to mitigate the economic impact of these failed policies, and this has led to increased borrowing to finance the expenditure. This increase in government borrowing could be reducing the effectiveness of monetary policy, as Bank of Ghana may be unable to control inflation when the government is borrowing excessively.

Additionally, the government’s fiscal policies could be creating macroeconomic imbalances. For instance, the government’s borrowing may be leading to an increase in the supply of money, which could be contributing to inflation. Moreover, government spending may also be leading to supply-side constraints such as bottlenecks in production, which could further exacerbate inflation.

To address this challenge, the Bank of Ghana may need to coordinate with the government to implement appropriate policies that support inflation targeting.

For instance, the bank may need to advocate for fiscal consolidation, where the government reduces its expenditure and borrowing to limit the impact of fiscal dominance on monetary policy. The bank may also need to work with the government to address supply-side constraints to reduce the cost-push pressures on inflation.

In effect, fiscal dominance is a significant challenge that can undermine the effectiveness of inflation targeting regimes. Therefore, it is essential for central banks to coordinate with governments to address macroeconomic imbalances and support the effectiveness of monetary policy.

Weakness in the Transmission Mechanism

The effectiveness of the inflation targeting framework depends on the strength of the monetary transmission mechanism, which refers to the process through which changes in the policy rate affect the economy.

The transmission mechanism in Ghana may be weak due to various factors such as a lack of liquidity in the financial system, weak institutional capacity, and the prevalence of informal markets. If the transmission mechanism is weak, changes in the policy rate may not have the desired effect on inflation. The effectiveness of the monetary policy transmission mechanism is crucial for the success of inflation targeting frameworks.

Firstly, the lack of liquidity in the financial system could limit the effectiveness of monetary policy. The financial sector in Ghana is relatively underdeveloped, and credit is not easily available to businesses and households. The lack of liquidity in the financial system could mean that changes in policy rates may not translate into changes in lending rates or credit availability, which could limit the effectiveness of the policy.

The prevalence of informal markets in Ghana could also limit the effectiveness of monetary policy. Informal markets are often unregulated and operate outside the formal financial system. These markets are often characterized by high levels of informality, low levels of transparency, and limited access to credit.

This could limit the effectiveness of monetary policy because changes in policy rates may not be transmitted to these informal markets, which could undermine the effectiveness of the policy.

To address these challenges, the Bank of Ghana may need to implement appropriate reforms to strengthen the monetary policy transmission mechanism. For example, the bank could work with other stakeholders such as commercial banks to improve the availability of credit to businesses and households.

Additionally, the bank could enhance its institutional capacity to improve regulation and supervision of the financial sector. Finally, the bank could work with other stakeholders to bring informal markets into the formal financial system, which could improve the effectiveness of monetary policy.

External Shocks

Ghana’s economy is vulnerable to external shocks such as changes in global commodity prices, particularly oil prices. These external factors could have a significant impact on inflation in Ghana. If these shocks are not taken into account, it can make it difficult for the central bank to control inflation.

Another possible reason why the Bank of Ghana’s inflation targeting regime may not be working effectively is due to external factors such as global commodity prices and exchange rate movements.

Ghana is heavily reliant on imports for several essential goods, such as oil, food, and machinery. Therefore, any increase in global commodity prices or exchange rate depreciation could significantly affect Ghana’s inflation rate.

For instance, if the price of oil increases globally, Ghana’s inflation rate could increase because the cost of imported oil would be higher, leading to an increase in the prices of goods and services that rely on oil. Similarly, if the exchange rate depreciates, the cost of importing goods could increase, leading to an increase in inflation.

Moreover, Ghana is highly exposed to external shocks such as climate change, which could affect the country’s agricultural sector, and geopolitical events, which could affect the country’s trade relations with its partners. These external factors could also affect the inflation rate in Ghana.

To address this challenge, the Bank of Ghana may need to adopt a more flexible inflation targeting regime that takes into account external factors. For instance, the bank could adjust its inflation target based on external factors such as changes in global commodity prices and exchange rate movements.

Additionally, the bank could use other policy tools such as macro-prudential policy to address external shocks that affect the financial sector and the economy as a whole.

External factors such as global commodity prices and exchange rate movements can significantly affect Ghana’s inflation rate, which can undermine the effectiveness of the Bank of Ghana’s inflation targeting regime. Therefore, it is essential for the bank to adopt a more flexible approach that takes into account external factors to support the effectiveness of monetary policy.

Structural Problems

Structural problems such as supply-side constraints, limited infrastructure, and low productivity could lead to persistent inflationary pressures in Ghana. Weak institutions, corruption, and political instability could also undermine the credibility of the central bank, which could make it difficult for it to achieve its inflation targets.

Structural challenges refer to long-term issues within the economy that affect the production capacity, productivity, and competitiveness of the economy. In Ghana, some of the structural challenges that could affect the effectiveness of the inflation targeting regime include weak infrastructure, low productivity, and a narrow export base.

To address this challenge, the Bank of Ghana may need to coordinate with the government to implement structural reforms that address these long-term challenges. For instance, the government could invest in infrastructure to improve the cost of production and delivery of goods and services.

Additionally, the government could implement policies that promote productivity, such as improving the education system, supporting research and development, and promoting innovation. The government could also implement policies that diversify the economy by promoting non-traditional exports and developing new sectors.

Sstructural challenges within the economy can affect the production capacity, productivity, and competitiveness of the economy, which could limit the effectiveness of the Bank of Ghana’s inflation targeting regime. Therefore, it is essential for the Bank of Ghana to coordinate with the government to implement structural reforms that address these challenges and support the effectiveness of monetary policy.

Exchange Rate Dynamics

Under the flexible exchange rate regime, changes in the exchange rate could affect the inflation rate. If the exchange rate depreciates, it could lead to higher import prices, which could push up inflation. The Bank of Ghana may not have enough control over exchange rate dynamics, and this could limit its ability to control inflation. Another possible reason why the Bank of Ghana’s inflation targeting regime may not be working effectively is due to limitations in the transmission mechanism of monetary policy.

The transmission mechanism refers to how changes in monetary policy, such as changes in interest rates or reserve requirements, affect the behavior of households and firms and ultimately impact the economy’s overall level of inflation. In Ghana, some of the limitations in the transmission mechanism that could affect the effectiveness of the inflation targeting regime include high levels of informality, weak financial intermediation, and an underdeveloped capital market.

High levels of informality mean that a significant proportion of economic activities occur outside of the formal financial system, which limits the effectiveness of monetary policy. For instance, households and firms that operate informally may not respond to changes in interest rates or other monetary policy tools.

Additionally, weak financial intermediation means that the banking system may not effectively transmit monetary policy changes to the broader economy. Furthermore, an underdeveloped capital market limits the availability of long-term financing, which could limit the effectiveness of monetary policy in addressing structural challenges.

To address this challenge, the Bank of Ghana may need to implement policies that improve financial intermediation and deepen the capital market. For instance, the bank could promote financial inclusion and encourage the development of microfinance institutions that serve informal sectors.

Additionally, the bank could implement policies that improve the regulatory environment for financial intermediaries, such as reducing the cost of credit and increasing the availability of credit to small and medium-sized enterprises. Furthermore, the bank could promote the development of the capital market by introducing new financial instruments such as bonds and derivatives and encouraging the listing of firms on the stock exchange.

In conclusion, limitations in the transmission mechanism of monetary policy could affect the effectiveness of the Bank of Ghana’s inflation targeting regime. Therefore, it is essential for the bank to implement policies that improve financial intermediation and deepen the capital market to support the effective transmission of monetary policy to the broader economy.

Lags in Policy Implementation

There may be a lag in the implementation of monetary policy. Monetary policy may take some time to have an impact on the economy, and if the Bank of Ghana is not proactive in adjusting its policy settings, inflation may persist at high levels. Additionally, there could be delays in the implementation of policy decisions due to administrative or logistical issues.

In conclusion, there could be several reasons why the Bank of Ghana’s inflation targeting regime is not working. To address these challenges, the Bank may need to review its policy framework and implement appropriate reforms to address any weaknesses in the policy transmission mechanism, enhance fiscal discipline, address structural problems, and improve the effectiveness of the flexible exchange rate regime.

Additionally, the Bank may need to work closely with other stakeholders, such as the government, to address the challenges that affect the effectiveness of the inflation targeting regime. Another possible reason why the Bank of Ghana’s inflation targeting regime may not be working effectively is due to external factors beyond the control of the bank.

External factors refer to economic and financial developments outside of the domestic economy that could affect the effectiveness of monetary policy. In Ghana, some of the external factors that could affect the effectiveness of the inflation targeting regime include volatile commodity prices, global economic conditions, and exchange rate fluctuations.

Volatile commodity prices, particularly for Ghana’s primary exports such as gold and cocoa, could affect the country’s terms of trade, which could lead to changes in inflation. For instance, a decline in commodity prices could lead to a deterioration in the country’s trade balance, which could put pressure on the exchange rate and ultimately affect inflation.

Global economic conditions, particularly in major trading partners such as China, the United States, and the European Union, could also affect Ghana’s inflation rate. For instance, a slowdown in the global economy could lead to a decline in demand for Ghana’s exports, which could affect the country’s terms of trade and ultimately affect inflation.

Exchange rate fluctuations could also affect Ghana’s inflation rate. In a flexible exchange rate regime, changes in the exchange rate could affect the prices of imported goods, which could affect inflation. Additionally, exchange rate fluctuations could affect inflation expectations, which could affect the behavior of households and firms and ultimately impact inflation.

To address this challenge, the Bank of Ghana may need to monitor and analyze external developments that could affect the economy and adjust its monetary policy accordingly. Additionally, the bank may need to implement policies that promote economic diversification and reduce the country’s reliance on primary commodity exports. Furthermore, the bank could implement policies that promote stability in the exchange rate, such as managing capital flows and maintaining adequate foreign exchange reserves.

Conclusion

In conclusion, Ghana’s adoption of an inflation targeting regime in 2007 was a significant step towards achieving price stability, but the country has struggled to meet its inflation targets in recent years. The reasons for this include fiscal dominance, weak institutions, supply-side shocks, and limitations in the transmission mechanism of monetary policy. Moreover, the central bank financing of government operations to the tune of over 90 billion cedis in 2020 to 2022 has contributed to high inflation, undermining the effectiveness of the monetary policy.

Ghana urgently needs fiscal sustainability to address the challenges of high inflation and promote sustainable economic growth and development. Fiscal sustainability refers to a situation where the government’s revenue is enough to cover its expenditure, and it is not borrowing excessively from the central bank to finance its operations. Achieving fiscal sustainability would require the government to adopt policies that increase revenue generation, reduce wasteful expenditure, and improve public financial management.

Furthermore, improving institutional capacity and reducing supply-side constraints, such as addressing infrastructure deficits and improving the ease of doing business, would promote sustainable economic growth, job creation, and reduce inflationary pressures. The Bank of Ghana also needs to strengthen its monetary policy framework, enhance the effectiveness of the transmission mechanism of monetary policy, and address the limitations of the inflation targeting regime to achieve its inflation targets.

In summary, Ghana needs urgent fiscal sustainability to address the challenges of high inflation and promote sustainable economic growth and development.

Achieving fiscal sustainability would require concerted efforts by the government and the central bank to adopt sound macroeconomic policies, strengthen institutional capacity, and reduce supply-side constraints.