Inflation expectations

Hyper or soaring inflation is the worst nightmare for the economic managers of a country. Reuters, the international news agency, has said that Pakistan could face this unfortunate situation if appropriate measures were not taken in time to counter the menace. Inflation in the country is at a level where the jump to hyper-inflation will be easy.
Consumer prices in March, 2008 were 14.12 percent higher than a year ago, pushing inflation to its highest level in 13 years and spelling trouble for the economy that has notched up average growth of seven percent a year since 2002.
The main reason for this malady is the widening fiscal deficit which had risen to 4.7 percent of GDP in the first eight months of the current fiscal year and could exceed nine percent during 2007-08 if nothing is done to control it. The government's financing needs had ballooned, a large chunk being spent on consumer subsidies on fuel and food, and the central bank was printing too much money to finance the government's lavish spending, a factor that had kept money supply growth at a high level.
Another problem was that political upheaval of the past year had scared foreign investors and retarded foreign capital inflows, while at the same time the government's unbridled borrowing and spending had pumped more cash into the economy and exacerbated price pressures.
Rising import costs had widened the trade deficit, pressuring the rupee which hit a six and half year low this week. There is talk that Pakistan's already sub-investment grade ratings may be cut further and that the authorities may be forced to ask the IMF for money.
There are high expectations from the State Bank for a rescue operation. Governor Shamshad Akhtar has earned the admiration of market players and investors who are keen to see some tough and fast action from the State Bank. Reuters is of the view that the SBP risks losing credibility unless it acts fast to rein in soaring inflation and preferably before July, when its next regular policy review is due.
In addition to the fiscal constraints, the monetary authority needs to signal that it wants to take inflation head-on. At present, the policy rate at 10.5 percent is the second highest in Asia, but inflation-adjusted real interest rates are negative, meaning that consumers are tempted to spend rather than save their money.
An upward movement in policy rate would help in several ways. The rupee's decline would become slow, and higher yields would rein in consumer spending and make it more expensive for the government to borrow from the market. Higher borrowing costs could have an effect of forcing the government to cut back spending and rationalise its expenditures. The SBP needs to persuade the people that it is actively on the case.
We feel that apprehensions expressed by Reuters are not entirely unfounded and the policy thrust proposed by it is generally relevant to the prevailing situation. Inflation in the recent past has accelerated at a pace and both the Shaukat Aziz and caretaker governments had been so indifferent to this gigantic problem that it was but natural for the independent analysts to sound the alarm bells and that is what Reuters has actually done.
Inflationary pressures have been fuelled by injections of higher doses of liquidity in the economy due to record borrowings by the government from the State Bank to finance its increasing budget deficit. Only financial constraint and strict budgetary discipline by the government could reverse this vicious circle and restore price stability in the country.
As the latest actions and policy statements of the new government indicate, it is not only fully conscious of the risks involved but is also prepared to take the bull by the horns. In its short life of only few weeks, it has issued an elaborate fact sheet of the economy and initiated several harsh measures, including a substantial increase in the domestic fuel prices to lower the budget deficit.
The most redeeming feature is, that the new government has not yielded to the popular pressure of providing relief and facilities to the people. All of this augurs well for the prospects of the economy. In particular, if the government is able to suppress inflationary pressures through prudent fiscal management in the face of high international prices of oil and food, it would be a tremendous achievement.
The realisation on the part of the government that the situation is grave and calls for tightening of fiscal stance is indeed satisfying. Looking at the resolve of the government, we feel that the fears of independent agencies like Reuters would tend to diminish and their confidence in the resilience and stability of the economy would grow over time.
Reuters, like some other independent analysts, has a great degree of faith in the ability of the State Bank to conduct monetary policy in a way so as to neutralise the negative impact of an expansionary fiscal stance. Such a confidence is not entirely misplaced after the grant of autonomy to the State Bank, but we would urge such elements to see the picture in totality.
The monetary authority has been advising and even warning the government after the grant of autonomy to reduce its fiscal deficit and put its house in order more forcefully but, in our view, its Board will never go to the extent of cutting of the flow of financial resources from the banking system entirely and cripple the normal functioning of the government.
Our view is based on the premise that the State Bank is fully aware of the fact that its autonomy, earned after a great deal of effort spanning over a number of years, could again be curtailed by a change in legislation, if the Parliament concludes that the central bank of the country has become too obstructive and un-accommodative.