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Rising interest rate – is it the right way to control inflation?

Rising interest rate – is it the right way to control inflation?

The State Bank of Pakistan has raised key interest rate by 125 basis points and now, the interest rate is 15%. SBP did it due to rising inflation in the economy. The inflation is rising day by day in the economy. In June 2022, the inflation rate recorded at 21.32 percent last as compared to the corresponding month of 2021.

This is the simple economic formula that when inflation rate is high in the economy, it means that money supply is increasing in the economy due to which demand increases and when demand increases, the price also increases and subsequently, the inflation rises in the economy. In this situation, the central bank adopts several measures to decrease circulation of money in the economy. Among the several measures, one measure is to rise the key interest rate due to which the loans etc. would be expensive and the money supply would be decreased in the economy due to which the demand would be lowered and price would also be lowered respectively.

One question arises here that “Is this step would curtail the inflation in every situation of inflation?” The answer is Absolutely Not because the causes of inflation may be different. The inflation rate does not always rise due to the factor of money supply in the economy. Therefore, there is a need to consider the cause of inflation and take steps accordingly. If the step is taken without determining the real situation, the issue will be worsen.

At present, the inflation rate is awfully rising and the significant cause of inflation is rising in petroleum prices as it effects upon every segment of the society. Besides this, the rising internal and external debts are badly disturbing our economy. These loans have become main issue for the development of tour economy. The government try to pay debts by imposing several taxes and reduction of subsidies etc. due to which people pay direct and indirect taxes and it effects the inflation rate directly or indirectly.

In the present budget, the figures show the large dependency of budget upon the foreign loans and taxes. 41.5% of the total budget i.e. PKR 3.95 trillion will be spent on just debt servicing this fiscal year. It means that the large portion of our budget will be eaten by the debt and to tackle the deficit in budget, the nation will get more debt and this process is not expected to an end. When the government imposes taxes on the corporate sector, it leads to increment of prices etc. because the corporate sector adds these taxes in the prices and ultimately, the final consumer and individuals would pay this cost. These taxes are seriously threatening the people of Pakistan. There is a consistent rise in electricity and gas bills due to which the corporate and individual sectors are badly damaged. The continuous load shedding is baldy effecting the people of Pakistan particularly corporate sector as in case of load shedding, the production processes are effected and if the business unit produces its own electricity, the cost would be added to the prices.

Is the above mentioned sketch of the socio-economic scenario of inflation the issue of “Money Supply” in the economy? The answer is Absolutely Not. Then why the central bank and the government are not considering the real causes and act accordingly.

In the present scenario, the people are continuously losing their purchasing power. The domestic budget of poor, middle class and upper middle classes is heavily increased and effected upon their lifestyle. The corporate sector is also facing serious economic crises. In this situation, the rising interest rate would cause more economic unrest in the country. The formula of rising interest rate might be beneficial for the economy where the people have high purchasing power due to which demand increases and consequently, the prices increase but in our economic situation, this formula is not applicable at all.

Due to this decision of high interest rate, the consumer financing would be badly lowered and the corporate sector would face more economic cost which would be added in the consumer prices. Therefore, this decision would cause more inflation, low purchasing power and socio-economic distress in the nation.

Rather than making these unrealistic steps, there is a need to tackle the real issues that are effecting our economy. The wrong steps would lead to more uncertainty but the right steps in the right direction may help to stabilize the economy.

The author is a Director- Global Institute of Shariah Research & Advisory Services
Team Leader-Training & Development Unit, Shariah Compliance Department, National Bank of Pakistan

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