Those who had studied closely the State Bank's first quarterly report for FY05 released only about three weeks ago must feel puzzled by the sudden change in tone in the Monetary Policy Statement (MPS) issued on 19th January, 2005. The quarterly report gave the impression as if enough tightening of monetary policy was imminent in the very near future to ward off inflationary pressures. The inflationary expectations were termed as downward risk and it was noted that maintaining low interest rates for an extended period in the face of high inflation was counter-productive for the economy.
This stance was further reinforced by explaining that "average lending rates are already negative, and a continuation of this would encourage non-productive borrowings and speculative activities. Accordingly, it would be prudent for the central bank to carefully monitor developments in the light of December, 2004 data and to assess whether the balance of risks justifies a further tightening of monetary stance."
Authors of MPS had of course now the benefit of the availability of December, 2004 data which indicated the necessity of a tough stance. It was noted that "the consumer price inflation remained on the higher side and during July-December, 2004 it was recorded at 8.8 percent compared with 3.1 percent registered in the corresponding period of last year.
The constrained supplies of primary food items jacked up the food price inflation to 12.6 percent during July-December, 2004 from 3.4 percent in the comparable period of last year." The core inflation was still heading upwards. As regards liquidity in the economy, the growth of key monetary indicators remained strong. In particular, the growth of reserve money continued unabated as it expanded by 15.4 percent during July-December, 2004 compared with the expansion of 16.4 percent in the corresponding period of last year.
However, despite this evidence suggesting a marked shift in policy, the State Bank, instead of indicating a very stringent action, seems to have changed its line of reasoning in the MPS.
Although, on the basis of the balance of risks, it has hinted at a shift from an accommodative to neutral monetary policy stance during the next six months to control the accelerating trend in inflation yet so many other factors have been brought into the overall picture that the priority of fighting the menace of inflation seems to have lost its earlier importance. According to the MPS, "fighting inflation would remain the primary objective of monetary policy but higher economic growth, production, employment and capacity expansion would neither be abandoned nor stifled.
The State Bank of Pakistan would, therefore, continue to tighten the monetary policy by raising interest rates but maintain a healthy balance between suppressing inflation and facilitating investment, growth and employment in a non-inflationary environment."
The concluding sentence of the MPS is even more confusing when it says that "SBP would ensure through the conduct of monetary policy that the adjustments in rates do not retard the process of economic growth." Should it be inferred that the State Bank now cares more about economic growth than inflation or trying to simultaneously achieve various objectives which may be inherently incompatible?
We do not know the reasons for this shift in stance during such a short period without any apparent compulsions but the State Bank, like any other central bank, needs to focus almost entirely on its primary task of maintaining price stability. The unnecessary attempt at creating confusion on the trade-off between inflation and growth as emphasised by the MPS also needs to be discarded because growth is more sustainable in a non-inflationary environment due to certainty in decision making.
Also, the State Bank should try to reduce huge monetary overhang of the past few years when the inflation rate, to a large extent, is yet manageable. During the current year, monetary expansion is estimated at 13.4 percent which will be only slightly lower than the increase in national income in nominal terms and certainly not enough to absorb any significant part of the monetary overhang of the previous years.
Continued injection of high doses of reserve money together with substantial increase in consumer loans would add further pressure on prices, particularly at a time when most of the consumer goods industries like automobiles are working at near full capacity. Obviously, there is also a need to redirect more and more credit to investment and basic industries to increase the productive potential of the economy and sustain consumer industries in the years to come.
Inflation rate for the current year estimated by the State Bank is 7 percent as against the target of 5 percent. It is of course disturbing that the central bank is allowing the inflation rate to rise beyond the targeted level but more disappointing is the fact that it seems to be content with this policy.
According to the MPS, "while the central bank should and would attack inflation in a central manner there is no solid empirical evidence either from Pakistan's own experience or cross country studies that low and decelerating inflation rates in the range of 5-7 percent have a strong pernicious effect on the economy." Yes, inflation of this magnitude may not have an adverse impact on overall growth but would definitely have a pernicious effect on the lives of ordinary people of the country, particularly the poor, especially when the prices of food items are increasing at a much faster pace and the growth, as such, is not promoting employment at the lower level due to increased computerisation and automation in the economy.
In fact, most of the business enterprises including PSEs and banks are shedding large number of employees of ordinary qualifications to make way for highly qualified professionals at fat salaries, thus reducing employment in aggregate terms and increasing income disparities.
Inflation of the magnitude the State Bank is talking about may be tolerable in countries where unemployment is low but could spread misery and despair in Pakistan. Also, the differential in inflation rate between Pakistan and the developed countries would force the country to depreciate its currency by about 4 percent per annum to keep its products competitive in the international market and this could become another contributory factor to feed the vicious cycle of inflation.
The State Bank needs to be aware that in a country like Pakistan the combination of inflation and unemployment could be highly explosive. Some of the other macro-economic gains often propagated by the authorities hardly matter to the people at large and could prove transitory. For instance, nobody could foresee that Pakistan would revert from a highly favourable situation in the external sector to current account deficit so soon.
This may be primarily because of an unanticipated increase in oil prices but the fact remains that we must always be on guard to preserve the macro-economic gains of the last few years including relative stability in prices. If these gains are lost one after another, all claims about trickle-down effect to improve the lot of ordinary people would lose their relevance. In the real world, weaknesses are not spared and attract appropriate punishment.
The State Bank could argue that it has increased six-month T-bill yields by over 200 basis points and is planning to do likewise in the next six months but, in our view, this effort would not be enough to counter inflationary pressures in a significant manner. The rates need to be raised to a point where they could contain rapid increase in credit and limit the monetary expansion to a level substantially lower than the rise in nominal GNP so as to neutralise the impact of existing monetary overhang.
There would hardly be any country in the world where even lending rates are lower than the inflation rate and the banking system becomes a vehicle in perpetuating inequalities by transferring resources from poorer to the richer sections of society and in the process also hurt saving rate of the economy. We would urge the State Bank to really concentrate on reducing inflation by tightening the monetary policy without further loss of time and not be overly concerned with other variables which may be taken care of by other departments of the government.
Again, the emphasis should not be on the size of increase in interest rates but its effectiveness to yield the desired result of containing inflation rate to around 5 percent. The State Bank is a better judge but increase in T-Bill yields by about 4 percent in the next six months may do the trick if other things remain unchanged.
The ground prepared in the first quarterly report was better attuned to this strategy. The MPS has added so many dimensions to the problem that the policy thrust of the State Bank during the next few months has become almost vague.
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