Managing easy monetary policy

With two consecutive downward adjustments of policy rates, many see it as a beginning of an era of easy monetary policy till the country is in an election mode. While the jury is still out there whether the easing will fuel inflation more than it will help growth, managing easy monetary policy implies that boost to growth outweighs the costs in terms of actual inflation and inflationary expectations.
A stylistic overview how SBP conducted the tightening and easing cycle in the last ten years will help to assess how long or short were these cycles and the limits of these cycles. The last time the policy rate was 12 percent was in June/July 2008, three years ago. It was 14 percent in June 2001. In a matter of 18 months, it was brought down to 7.5 percent. It remained there for the next two and half years when in April 2005 it was increased to 9.0 percent. It took 4 years for SBP to raise it to 14 percent by April 2009. Thus one can infer that in the last 10 years easing cycles were much shorter and faster than the tightening cycles.
Of course, in a two-way cause and effect environment, inflationary trends and expectations, growth prospects, interest rate parities and exchange rate also matter in determining the length and extent of these cycles. However, the length of the cycles suggests that interest rate policy has remained pro-growth more than it has remained anti-inflationary, except in the last 3 years under the IMF programme. Given that imported inflation and currency under pressure is likely to transmit rapidly to local inflation, along with supply bottlenecks there is not enough room to emulate the previous easing cycle of 18 months unless SBP succumbs to the political pressure.
Does the previous easing cycle carry some lessons for promoting growth? Do lower interest rates raise growth and to what extent? If the impact is positive than what is the nature and composition of growth? Does it promote exports, specifically of manufactured exports, or much maligned consumption growth in durables and import intensive manufactures?
The writer conducted a back of the envelope exercise and based on the last 5 years macro data, it revealed that 1 percentage point (ie, 100 basis point) decline in policy rate increases the annual growth rate in manufacturing by 0.20 percent and growth rate of GDP by 0.27 percent. In case of manufacturing, its historical performance was instrumental in determining the positive impact of the interest rate, while GDP growth rate technically followed a random walk.
Furthermore, it indicated that to achieve the manufacturing and GDP 2011-12 growth targets, lowering interest rates by a further 200 and 100 basis points, respectively, can be conducive (do not equate it with the word 'ensure') for achieving this year targets. Ideally, this is the extent to which the easing cycle should go during the year, unless there is a compelling favourable external and internal economic environment.
Since it is a back of the envelope exercise lending rates impact on growth rate should not be linearly extrapolated to achieve an above target growth rate. The trade-off between growth and inflation comes out very clearly even in this simple exercise. A 100-basis point decrease in policy rate increases CPI by 0.24 percentage points but after a lag of 3 months. What are the observed transmission impacts on growth that can be attributed to the easy monetary policy during 2001-05?
A) Consumer credit is fairly sensitive to lower interest rates. This type of credit was widely used to buy durables, and transport equipment specifically automobiles and two-wheelers in 2001-08 era. Cheap credit generated demand of these import intensive durables does help local manufacturing and employment, but also increases import bill. At the time, increased FDI did help to cushion the increasing import bill, but in times of falling FDI cheap consumer credit spent on import intensive durables can de-stabilise the already precarious BoP situation.
B) Housing is another sector that receives a boost from lower interest rates. The forward linkages of a booming housing sector in terms of pulling along another 14-17 sub-sectors in the manufacturing sector is well documented. However, it is a resource intensive sector, in terms of cement, iron and steel, wood, plastics and glass. Thus in an environment of higher or at best fluctuating world-wide raw material demand any increase in domestic demand due to lower interest rates will translate faster into higher prices than rapid increase (punctured by energy shortages) in output. In the previous easing interest-rate cycle, a stable exchange rate, low inflation, uninterrupted energy supply and stable international prices helped to create a mini housing boom in the construction related industries.
C) Three types of speculative unproductive investment are lucrative for speculators in time of falling interest rates and are intimately linked to increase liquidity and credit 'fungibility' in the economy. Property: Once there is enough liquidity in the system at low interest rates, investment into property fuels a vicious cycles of speculation into property and housing values, backed by weak regulatory framework and institutional private and public sector poor documentation. Increasing remittances are already sustaining the private property, housing and construction activities (maybe not at the scale of earlier easing or to the extent the populist government would want to showcase) and further easing of interest rates would create a boom-and-bust cycle as witnessed during the 2001-2008. A caveat is in order here. The previous property boom was also somewhat supported by financial transfers due to war on terror, internationally low interest rate environment, accompanied by excess international liquidity. Stocks: Investment in stock exchange in times of low interest is attractive on two counts. It increases the differential between the interest rates on borrowed funds by speculators and the rate of return (capital gains) on short-term investment. Secondly, it also improves the balance sheet of listed companies improving their P/E ratios. To the extent that rising stock market is able to attract portfolio investment from foreign investors, it helps the foreign exchange reserves. Will the current easing cycle, speedup the flow of portfolio investment as it did during mid decade and took flight out in 2008? In spite of sovereign debt crisis in the West, the current easing cycle could boost portfolio investment, as rising prices increase the profitability of listed companies, but the structural bottlenecks in the economy and the elevated risks of depreciating currency do not favour repeat of the 2002-2006 scenario. The foreign investor may wait for another round of easing and BoP situation by March 2012. Speculative Imports and inventory investment: In times of weak exchange rate, and high domestic inflation, low interest rates also encourage speculative imports. Thus SBP needs to keep a watch on above normal short or medium term trends in imports especially in case of consumer goods. Inventory investment is also attractive in times of low interest rates and high inflation, but can be instrumental in boosting production if there is sufficient under capacity utilisation in the manufacturing sector. But given the rigidities in agriculture production, inventory investment is likely to push prices rather than output.
A similar back of the envelope exercise linking growth in exports to policy rate could not be conducted due to lack of data. However a dated work by the writer indicated that one percent increase in incentive index (composed of customs rebate and export refinance rates) only increased export by 0.7 percent to the US, while it had no impact on exports to Germany, Britain and Japan.
Lastly, the issue of 'fungibility' of easy credit in the transmission mechanism is a formidable challenge in effectively managing an easy monetary policy. In other words it is the recorded/perceived versus the actual use of credit. Are there checks in place that ensure synchronisation of recorded with the actual use of credit? How does one ensure that loan to agriculturist does not increase his capacity to hoard wheat rather than buy inputs to bring additional land under cultivation? Sectoral classification of credit however tight can blur the end-use purpose of loans. Loans to cement stockiest can be conveniently classified as loans to construction industry. The 'fungibility' issue cannot be dismissed lightly in this economy, where owners of floor-mills, cotton ginning operations, petrol pumps, fertiliser steel, ghee and sugar stockists yield directly or indirectly considerable clout in the national and provincial assemblies. Unfortunately no central bank can ensure perfect synchronisation of millions of loan accounts and the extent of 'dis-intermediation' is a function of presence of opportunities to make a quick return in the market.