The State Bank of Pakistan (SBP) made an unexpected move by increasing its benchmark interest rate by 150 basis points to 8.75 percent in its announcement on November 18 as the central bank facing surging inflation and other challenges regarding stalled International Monetary Fund (IMF) loan facility.
The central bank noted there was a need to proceed faster with the normalization of monetary policy to counter inflationary pressures and maintain price stability as inflation had reached 9.2% in October, compared to 8.4% at the time of the last meeting, mainly driven by prices of food & non-alcoholic beverages and housing & utilities.
Policymakers said high import prices were contributing to higher-than-expected inflation rates but also pointed that demand-side pressures and inflation expectations of businesses were emerging. Additionally, the September and October balance of payment deficits were larger than anticipated, which has significantly weakened the rupee. Looking ahead, the committee reiterated that the goal of mildly positive real interest rates remained unchanged and expects to take measured steps to that end.
Analysts said reason for increasing frequency of decision making meetings is to follow practices adopted by the best central banks across the world.
As per SBP’s Monetary Policy Committee, there is now a need to proceed faster to normalize monetary policy to counter inflationary pressures and preserve stability with growth. It seems that the ultimate objective of mildly positive real interest rates remains unchanged. Many analysts had been expecting the central bank to lift rates, but the size of the hike was beyond most expectations. This increase is in a bid to contain runaway inflation, which threatens to destabilize the economy, which is already in bad shape. Interest rates are used by the central banks as a tool to control inflation, regulate unnecessary movements in currency rates and give guidance to the national economy.
The Role of SBP
Role of central banks (CB) and monetary policy (MP) has changed over the time especially in the last century. Initially, MP was believed to have little or no effect in stimulating economic growth. However, the role of CB has changed significantly over time. The objectives of CB are to stabilize price level, ensure availability of credit to business, control unemployment, and to stimulate economic activities in a country. Theoretically, it is believed that the CB uses different tools to stabilize economy like monetary base, reserve ratio, policy rate, etc.
The SBP ACT
The SBP Act 1956 envisions SBP’s to regulate the monetary and credit system of Pakistan and to foster its growth in the best national interest with a view to securing monetary stability and fuller utilization of the country’s productive resources. SBP focuses on achieving monetary stability by controlling inflation close to its annual and medium-term targets set by the government. At the same time, SBP also aims to ensure financial stability, particularly the smooth functioning of the financial market and the payments system. Consensus in literature as well as country experiences suggests that price and financial stability facilitate the achievement of sustained economic growth in the long-run.
Interest Rate as a Policy Tool
Globally, the use of interest rate as a policy tool has a long tradition. However, its impact on economic growth is inconclusive. There are two main components or views. Firstly that higher interest rate lowers investment and hence growth, and the secondly that increase in interest rate improves the efficiency of investment and accelerate economic growth. However, despite the nature of relationship, direction of causality is also inconclusive. It could be because of using different data span, countries and most importantly the use of traditional asymptotic theory based econometric approaches like testing for possible unit root and/or co-integration.
Apparently the SBP’s decision to increase the interest rate to 8.75% has been taken because of risks related to inflation. Now, there is a need to proceed faster to normalize monetary policy to counter inflation and preserve stability with growth; with risks rotating from growth to inflation and the current account faster than expected. The Monetary Policy Committee (MPC) is constricted interest rates keeping in view the rising inflationary pressure due to rupee depreciation, a potential increase in utility tariffs and an upward trend in prices of petroleum products and essential food items in global markets. It has been noted that inflationary pressures had increased considerably since its last meeting, with headline inflation rising from 8.4pc year-on-year in August to 9pc in September and further to 9.2pc in October. It said this increase was mainly driven by higher energy costs and a rise in core inflation.
The Inflation in Pakistan has increased markedly with the resumption of economic activities but as supply-side inflation has subsided, demand-side inflation has overshot. Headline inflation initially remained low averaging at 8.7% during 4MFY22, but now, even with the base effect waning, it has started accelerating, raising concerns.
In its previous policy review, the central bank had increased the benchmark policy rate by 25 bps to 7.25%. Accordingly, the real interest rate was recorded at negative 2%, as inflation reading came in at 9.2% in October.
SBP is expected to remain hawkish, raising its policy rate for the second time since the beginning of FY22 and at a much higher magnitude of 100bps taking the total cumulative increase in FY22 to date to 125 bps; which is the highest hike in more than 2 years.
The SBP’s warning comes as high inflation continues to hit the country’s sizeable poor and middle classes as prices for essentials such as food and fuel climb ahead of the cooler winter months. With regards to the fall of the rupee, the currency had depreciated by 3.4pc since the last MPC meeting in September. The US dollar also appreciated against most emerging market currencies since May however, the fall in the value of the rupee has been comparatively large. As other adjustment tools normalize, including interest rates and fiscal policy, pressures on the rupee should decrease.
Due to obstinately high commodity prices in the international market and strong domestic activity kept the current account deficit elevated at $3.4 billion in the first quarter of FY22. The deficit widened to $1.66bn in October from $1.13bn in September due to high energy prices and an uptick in services imports, despite some moderation in non-energy imports. There was also a moderate month-on-month decline in exports and remittances. The current account deficit for FY22 is expected to modestly exceed the previous forecast of 2-3pc of the GDP.
Pakistan’s Economic Position
Pakistan is in the headlines for high inflation. The Economist has ranked Pakistan the fourth highest inflation economy in the world out of 43 high-inflation economies. Headline inflation increased to 9.2 percent in October from 9 percent in September. Pakistan is expected to experience higher inflation throughout 2022. Higher and volatile inflation has economic as well as social welfare implications. It erodes the purchasing power of the people. It does more so for the poor who have lower income and spend almost half of it to buy food. In countries like Pakistan, where wage growth is low, high inflation can push many below the poverty line.
Despite the fact that inflation in India stood at 4.3 percent in September, the government offices in continue to claim that it has done the best in the world to control inflation including the statement that the petrol prices in the country are lower than India, Bangladesh and even the US.
There are many factors, are beyond government control for example the international commodity prices and that inflation is a global phenomenon. However, Pakistan is clearly having a much higher level of inflation. Prices of commodities are rising with every passing day.
The SBP’s Monetary Policy Framework is mandated to control it, in order to maintain monetary stability, inflation is close to annual and medium-term targets set by the government. With such an approach, monetary policy delivers on inflation targets but with eroded purchasing power.
The government-stipulated inflation targets change frequently and erratically, often so by wide margins making it challenging to anchor inflation expectations. A working from SBP shows that the target of inflation moved to 12 percent in 2012 from 5 percent in 2004. Even if the SBP delivered 100 percent on it, it will have eroded the purchasing power of the people.
The monetary policy in Pakistan was not shaped in terms of price stability and the purchasing power of the people. The race to meeting inflation targets led to volatile and unpredictable movements in the interest rates. Sudden shifts in monetary policy directions, from tight monetary control to an easy one and vice versa, flooded the market with uncertainty. Most importantly, the expectation formation of people was distorted. Higher average levels of inflation became a norm.
Monetary Policy and Price Stability
Monetary policy of the country should deliver price stability. All necessary arrangements must be made. The SBP, through its SBP Act 2021, is pushing for a number of fundamental structural changes.
The proposals include establishing an autonomous and independent central banking authority in the country while also redefining monetary policy objectives. These changes will generate significant consequences for social welfare, poverty and inequality in the country in addition to effects on macroeconomics.
There are three main channels through which central bank independence can result in higher inequality:
- Central bank independence indirectly constrains fiscal policy and weakens a government’s ability to engage in redistribution.
- Central bank independence incentivizes governments to deregulate financial markets, which generates a boom in asset values. These assets are predominantly in the hands of wealthier segments of the population.
- To contain inflationary pressures, governments actively promote policies that weaken the bargaining power of workers.
The Social Footprint
Sustainable Development Policy Institute’s has given suggestions about social footprint of monetary policy. It recommends a number of key actions and strategic policy directions, to help the SBP keep in line with modern practices in central banking and progress on the agenda of social footprint of monetary policy. Price stability is critical for social welfare, particularly for low-income households. The inflation target must be defined with a focus on the welfare of the public at large, instead of random so-called growth enhancing inflation targets. It must improve real wage in the short run and productivity growth in the medium to long term.
The SBP must adopt an inflation-targeting regime in order to contain inflation at a given level, thereby maintaining price stability and preventing purchasing power from being eroded. However, given the socioeconomic structure of Pakistan, low and volatile economic growth, a high degree of informality, high inequalities of income, consumption, wealth and employment, and fiscal policy importance, an “Integrated Inflation Targeting” should be employed, instead of a standard model of “Inflation Targeting Regime”.
The level of inflation to be targeted will be critical. 3 percent may be worth considering. The SBP may start with targeting around 5% inflation and move towards targeting an average inflation of 3% percent with deviations of -1 and +1. This range can substantially reduce the income and consumption inequality imposed by higher inflation. This will help reduce poverty through creation of more job opportunities, increased income and purchasing power on account of higher economic growth and lower inflation. It can also minimize adverse effects of monetary policy that arise from a very volatile policy rate. Targeting core inflation, which increases the command and control of the SBP, can help to a great extent.
There are three reasons.
- Sustainable and maximum employment reduces inequalities of income.
- It can guide the SBP to consider a policy mix that has favorable side effects.
- It is directly quantifiable, hence provides a stronger basis for accountability.
Ironically, the Government should understand that SBP’s Monetary Policy, has significant distributional effects. It cannot be undertaken in isolation from its socio-economic consequences. To keep in line with modern practices in central banking and progress on the agenda of social footprint of monetary policy, the SBP has much work to do in areas of communication, research and decisions-making.
It is high time that SBP to consider that its decisions and actions affect poverty, inequality and other social outcomes. Alternative types of monetary policy interventions that have the same aggregate effect. Households may have to borrow to meet other needs, such as health spending and education of children. A recent study from SDPI suggests that half of poor households in Pakistan are under debt. Most importantly, about 80 percent of these households defaulted on repaying their loans.
Higher food inflation can increase borrowing on the one hand, while further weakening the capacity to repay debt, on the other. Similarly, monetary policy decisions affect income, wealth and consumption inequality through several channels; difference in sources of income, portfolio composition, the sector and occupation of work, and the role of the credit market, such as savers and borrowers.
The formulation of welfare-enhancing short-term monetary policy must be informed by its social effects. Contrary to common belief, that monetary variables like money supply and interest rates do not have any real influence on the economy, researchers and policymakers are finding increasing evidence that monetary policy actions affect socio-economic indicators like poverty, inequality, unemployment.
Opponents to this idea generally argue that fighting inequality and reducing poverty is not the goal of monetary policy. Any proposal to reconsider the agenda of monetary policies is, therefore, unwarranted. It is important to note here that the new agenda in no way asks to replace price stability with poverty and inequality reduction. It simply suggests that monetary policy, like any other policy, must be considerate of the socio-economic impacts of its actions. Furthermore, recent research by the IMF suggests that inequality distorts the transmission of monetary policy and hurts its effectiveness. It must, therefore, factor into monetary policy decisions.
The inequality footprint of monetary policy is particularly more relevant for the SBP now as it aims to ensure greater autonomy. It actually advises that a more independent central bank has a larger role to play in fighting inequality, and that the existing framework, monetary policy actions, and instruments must be considerate of their social implications.
What could be done?
It is high time to focus on social outcomes at the very start of transition towards a more independent SBP adopting inflation targeting. The SBP must expand its research agenda to explore how its decisions and actions can affect social outcomes such as poverty and inequality. It must then work towards minimizing these adverse impacts.