It is hard to believe that a central bank could change its monetary policy on the basis of targets fixed by the government authorities, rather than the actual numbers or facts on the ground, but the announcement of the State Bank of Pakistan on 30th July, 2011 to reduce the policy rate by 50 basis points, reflects such a strategic shift in its analysis and stance.
The key parameter, according to the Monetary Policy Statement (MPS), affecting a change in the policy behaviour of the SBP, was a relative decline in average CPI inflation compared to earlier projections and the assessment that "indicates that average inflation in FY12 is expected to remain in line with the announced target." Backing its stance, the MPS adds that the government has acknowledged the persistence of inflation and announced an inflation target of 12 percent for 2011-12. It has also provided in the Medium-Term Budgetary Framework (MTBF) a desired path of inflation of 9.5 percent and 8 percent for the subsequent two years.
Supporting the inflation targets of the government, acting Governor Yaseen Anwar said that conditional upon factors such as adjustments in the administered prices of electricity and oil and projected broad money (M2) growth of 15 to 16 percent, SBP's forecast of average inflation also ranges between 11 and 12 percent for FY12. While defending a reduction in the policy rate, the State Bank also asserted that "no adjustment in the interest rate would have entailed further tightening of monetary policy in real terms, which is not warranted given the decline in private investment."
Some other arguments were also marshalled in favour of easing the monetary policy stance. It was highlighted that despite fiscal slippages, the government had adhered to restricting the stock of its borrowings from SBP to Rs 1.15 billion (on a cash basis). In fact, the government had retired these borrowings compared to both the end-June, 2010 level as well as the mutually agreed limit of end-September, 2010 level. The government had "also expressed its commitment to continue with a stance of zero borrowings from the SBP in yearly flow terms in FY12, which bodes well for anchoring inflation expectations." Also, a surplus in the current account was "an indication of somewhat restrained aggregate demand in the economy and therefore relative stability in inflation, albeit at a high level."
The State Bank's assessment was, however, much more objective in certain other areas of the economy. Although consolidated fiscal data had not been yet released by the government, but according to the MPS, provisional estimates from the financing side indicate that the fiscal deficit in FY11 may have reached close to Rs 1,127 billion or 6.2 percent of GDP. Excluding the one-off payment of Rs 120 billion to partially settle the circular debt in the energy sector, the fiscal deficit could, however, come down to 5.6 percent of GDP. Such a high level of fiscal deficit underscores the need to accelerate the implementation of fiscal reforms. Strangely, at another place in the MPS, the SBP has also shown a great degree of concern about the current price pressures by saying that a lower than projected inflation does not provide an enduring source of comfort, as it continues to show a high degree of persistence at an elevated level. Expectations of inflation were also fairly entrenched in the economy. Thus, a meaningful reduction in inflation would require consistent and credible implementation of monetary and fiscal policies. These observations were obviously at odds with the reasons offered to justify a reduction in the policy rate. The State Bank was also not very optimistic about the external sector outlook. It believes that after incorporating the recent declining trend in international cotton prices and likely continuation of international oil prices at around dollar 100 per barrel, projected growth rate of exports was 6 to 7 percent and that of imports was 10.5 percent to 11.5 percent and that could result in a modest current account deficit of 0.8 percent of GDP in FY12 in contrast to a surplus in FY11. "Given an increase in debt obligations and continued suspension of IMF's SBA, financing even a small current account deficit, could pose challenges in terms of maintaining an upward trajectory of SBP's foreign exchange reserves."
We don't know whether it is due to a change at the helms of the State Bank or a genuine shift in its policy strategy but a drop, however modest, in the discount rate at this juncture is definitely a matter of surprise, keeping in view its behaviour in responding to such situations in the past. Although, nothing could be said with absolute certainty, we strongly feel that, given the data now available on inflation and budgetary position, the previous governors would have successfully persuaded the Board members to keep the policy rate unchanged or raise it further to tame inflationary pressures and not depended on the official promises/commitments or targets to make a case for easing monetary policy which may please the government and business community of the country but is not defensible on economic grounds. In fact, one could only wonder on adopting an easy monetary policy stance when the State Bank's MPS itself observes that "the 12-month moving average of CPI inflation was 13.9 percent in June, 2011, exactly the same level observed in every subsequent month since December, 2010, and 4.4 percent higher than the target for FY11 and a meaningful reduction in inflation would require consistent and credible implementation of monetary and fiscal policies". All the evidence suggests that there is no let up in inflationary pressures in the economy and, therefore, there was no need to turn to a popular measure like a reduction in the policy rate. For instance, the latest available data indicated that CPI had increased by almost 14 percent during FY11 as compared to the target of 9.5 percent and the rise of 11.73 percent in the previous year.
Inflationary pressures were also mounting as suggested by the rise of 0.55 percent, 1.16 percent and 0.56 percent in CPI, SPI and WPI, respectively, during June, 2011 (the latest month for which the figures were available) over their levels in the previous month. A steep rise of 24.37 percent in the wholesale price index in June, 2011 over its level a year ago, was also a signal that inflationary pressures could accentuate in the coming months. The astonishing aspect was that the State Bank did not only put its faith in the inflationary targets given in the MTBF for the next three years, but also in the promise of reducing the fiscal deficit to 4.0 percent of GDP in FY12, and lowering the revenue deficit to zero in the same year.
One fails to understand how the State Bank could be so naïve so as to design its monetary policy on such hopes when the record of the government speaks for itself and it has even violated its commitments with the IMF with impunity in the past. We may also remind the State Bank that it is almost impossible to implement harsh measures in order to reduce the budget deficit in an election year. It also needs to be mentioned that private investment would not be encouraged by the reduction of 50 basis points in the policy rate since, at present, it is mainly held back due to low savings, poor law and order situation, increasing militancy, acute energy shortage and a host of other unfavourable factors.
While easing of monetary policy, in our view, was not justified at this point in time and the State Bank should have waited for emergence of related favourable developments, some of the observations contained in the MPS are of course based on a proper and in-depth analysis of the situation. For instance, its insistence on the removal of fiscal pressure emanating from PSEs and untargeted subsidies as well as implementation of speedy tax reforms and the possibility of a substantial current account deficit in FY12 speak loudly about the analytical capacity of the State Bank.
However, coming back to the point again, such a scenario calls for maintaining a tight monetary stance rather than loosening it prematurely, or in anticipation of certain favourable developments, which may or may not materialise. As a matter of fact, monetary policy is generally eased when there is proper evidence of softening of inflationary pressures in the economy and not on the basis of targets which are sought to be achieved mainly through a tight monetary stance.
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