Policy rate and oil subsidy — I

In its latest Monetary Policy Statement (MPS), released a few days ago, State Bank of Pakistan (SBP) raised policy rate by 150 basis points to 13.75 percent. As per his interview with Bloomberg, published as part of an article ‘Pakistan-IMF talks going well, take “bit of time”: Acting SBP governor Dr Murtuza Syed indicated that ‘…and so far in this monetary policy tightening cycle that we’ve undertaken since September, this brings the cumulative rate rise to 675 basis points.

Why did the monetary policy committee take this monetary policy decision? There were basically three main reasons: one is that inflation has been running pretty high in the last few months, it grows to 13.4 percent, a two-year high, last month, it’s been in double digits for the last six months, and in addition, core inflation is also looking high, almost 10 percent. So, it was very important to keep inflation expectations anchored. Secondly, the economy had to do with some cooling.

We’ve actually had a very rigorous rebound from Covid, the last two years we’ve had growth of almost 6 percent in both years, on the back of an unplanned fiscal expansion this year. So, from a macro point of view as well it makes a lot of sense to cool the economy down.

And third of course, Pakistan has been having some pressure on the external side, our reserves have been falling, we’ve had a pretty large current account deficit, which we are trying to moderate, and that this move of yesterday should help in that direction as well.’

With policy rate at 13.75 percent and inflation at 13.4 percent, the country is facing a positive real interest rate. To keep real interest rate as positive, in the traditional sense for a developing country (Pakistan) where in general inflation is at least equally a fiscal phenomenon, and not just mostly a monetary phenomenon, does not make much sense, but to have it when inflation is significantly determined by the global commodity supply shock — mainly oil and food — for almost a year now, and accentuated by the war in Ukraine by Russia where prices of oil were on an increasing path for a number of months even before that — primarily due to supply constraints as well, in addition to demand rebounded from the initial phase of lock-downs — does not hold ground at all.

And to say that core inflation is also rising is to miss the link of imported/supply-driven/cost-push inflation feeding into almost every sector of the economy, and does not just mainly show up in energy and food prices, given lack of governance/regulation of markets in terms of both lack of transparency/prevalence of collusive practices not allowing in general better price recovery and more justified extent of profiteering.

On the other hand, the raise in policy rate by 6.75 percent since September appears to have contributed to inflation through the channel of cost-push inflation, reducing in turn the purchasing power of a large section of society.

This is because there has been no increase in real wages, including real labour wages in the agriculture sector, nor has any meaningful reform in the agricultural markets taken place over the years, indicating, in turn, a lack of more correct price recovery for farmers in any meaningful way.

Moreover, rising prices of fertilizers, increasing costs of running tube-wells on generators run on oil, and the negative impact of extreme heave wave on wheat crop, for instance, have all meant that there has been no significant, broad-based betterment in purchasing power of farmers.

In addition, high economic growth rate during the last two years is mostly not on the basis of any meaningful sense of rising level of inclusive growth where apart from growth in the agriculture sector, about which the analysis above indicates not much increase in any broad-based increase in purchasing power, the other main determinant in the shape of large-scale manufacturing does not mean that small-and-medium enterprises (SMEs) have grown much, where rising policy rate both directly in terms of increasing cost of borrowing for SMEs, and indirectly through rising borrowing costs for government, has meant crowding-out of a large section of small business/investors, who are facing diminishing prospects of subsidised loan facilities from the government-backed programmes of the previous government, not to mention the difficulties it may raise for continuing to keep mortgage rate capped at a lower level.

So, instead of raising policy rate by 6.75 percent since September, only one or two percentage points should have been increased at most, given the main determinant of inflation being global supply shock behind rise in inflation, but also because inflation and policy rate have a weak relationship in Pakistan in view of the fact that the traditional lack of financial depth in the country means that demand-pull inflation is only one determinant of inflation, while the channel of cost-push inflation also remains an important determinant of inflation at the back of both imported inflation and weak governance/regulation for reducing market failures/imperfections.

Between January 2018 and May 2019, for instance, policy rate increased from 6 percent to more than 12 percent, yet inflation overall also showed an upward trend, rising from around 4.4 percent to 9.1 percent; where the falling part of inflation was less acute and for a relatively lesser time than the extent of rise, both in terms of magnitude and time of rise.

And that was before the global commodity supply shock, which has most likely only accentuated this weak relationship. This is because developing countries, which have a weak financial base to start with, could also provide little stimulus during the pandemic.

On the other hand, rich, advanced countries that provided more than $13 trillion as stimulus to their respective economies and have a much deeper financial sector to begin with are facing both a significant level of demand-pull inflation, in addition to a meaningful level of cost push inflation at the back of global commodity supply shock.

Hence, unlike the developed countries, which need to bring in a lot of monetary tightening as they seem to have provided more stimulus than needed and remain cautious in their tightening in view of the fact that inflation, after all, has also been caused significantly by supply shock, the developing countries need counter-cycle policies mainly and little monetary tightening/austerity policies in view of the fact that in developing countries like Pakistan inflation is currently more driven by supply shock than anything else.

(To be continued on Wednesday)

Copyright Business Recorder, 2022