The policy rate challenge

EDITORIAL: The Monetary Policy Committee raised the policy rate by one percent - to 21 percent - thereby linking the rate to core inflation (non-food and non-energy) that for March 2023 registered 18.6 percent (urban) and 23.1 percent (rural), giving an average rate of around 21.

The Committee viewed the increase in core inflation as partly driven by elevated inflation expectations. While expectations/sentiments are not quantifiable yet they do impact on markets and household behaviour patterns.

It is important to note that while the linkage between the policy rate on inflation in economic theory as well as in more developed economies is confirmed from empirical studies yet such a linkage has been tenuous at best in Pakistan.

This may have prompted the Monetary Policy Statement (MPS) to cautiously note (caution as opposed to discretion the better part of valour given extreme sensitivities of the federal government) that “the surge in inflation was broad-based, though a large part of it was contributed by food and energy components.

This reflects the pass-through of increases in taxes and duties, unwinding of untargeted energy subsidies and the recent exchange rate depreciation.” In other words, the blame for high inflation rests with the federal government and indirectly on the International Monetary Fund (IMF) for insisting on full cost recovery of utilities (read raise in electricity and gas prices) and fiscal consolidation (read higher revenue collections).

Considering that over 70 percent of Federal Board of Revenue collections are from indirect taxes, whose incidence on the poor is greater than on the rich, more and more people are being pushed below the poverty line.

Credit by banks to the private sector, at rates determined by the prevailing policy rate, is largely availed by the formal large-scale manufacturing (LSM) sector rather than small to medium enterprises or the large parallel informal sector.

Thus, while the prevailing strict regulatory limitations on imports, evident from the large number of containers that remain piled up at our ports, may have reduced the current account deficit through reducing imports, yet concurrently this is having a severe negative impact on domestic industry heavily reliant on imports of raw material and semi-finished products.

It is little wonder that LSM output decline accelerated in January to 7.9 percent year on year. To make matters worse, public sector borrowing is also crowding out private sector credit with the federal government pumping this borrowed money right back into the economy to meet its current expenditure (with almost zero growth potential). It is therefore little wonder that inflation is on the rise.

The MPS confirms this by noting that the “broad-based money growth showed a slight uptick in February primarily due to a significant expansion in net domestic assets of the banking system. This was largely on account of higher public sector borrowing as growth in private sector decelerated sharply to 11.1 percent in February 2023 from 18.6 percent in February 2022.”

Two further observations of the MPS are critical. First, it remains upbeat about reaching a staff-level agreement on the ninth review with the IMF by noting that “significant progress has been made towards completion of the ninth review under the IMF’s EFF programme.”

And reiterated that early conclusion of the ninth review is critical to rebuilding the foreign exchange reserve buffers. This would lead one to assume that, as in the past, the SBP consulted and implemented the agreed to policy rate raise with the Fund; however, one factor militates against this perception: the usual practice for setting the rate is a percentage or two above the core inflation (average) rather than level or less than 25 basis points.

It could well be that the Fund’s focus is on the much bigger issue of confirmation of external financing from friendly countries rather than on the policy rate that can easily be upgraded by insisting on the MPC meeting earlier than scheduled as in the past. It is also noteworthy that the 2nd March 2023 MPS noted that the decision to raise rates by 300 basis points “pushed the real interest rate in positive territory on a forward looking basis”, whereas no such claim was made in the 4 April MPS.

And second, the MPS notes that growth will be significantly lower than post-floods assessment of November 2022; however, it again cautiously does not specify how much lower.

In November, growth forecast was 3 percent, and even if one takes account of the tendency to overstate growth by governments in general and the incumbent economic team leader in particular, yet recent forecast by Asian Development Bank of 0.6 percent may also be an over-estimation, given Pakistan’s contracting economy due to government’s contractionary policy decisions and the World Bank’s forecast of 0.4 percent.

The MPS’ contention that “there are early indications of inflation expectations plateauing, albeit at an elevated level” requires clarification on two counts: (i) this may be a reference to the fact that the IMF conditions have been met in terms of achieving full-cost recovery with no further tariff raises envisaged in the short term; however, given that the full-cost recovery has been passed on to the hapless consumers rather than dealing with sectoral inefficiencies, the need to further raise rates may be felt sooner rather than later if past precedence is anything to go by.

One would have hoped for sectoral inefficiencies being tackled on an emergent basis; and (ii) what are these early indications referred to in the MPS, given that the month-on-month increase in core inflation in March was 2.5 percent - the highest since March 2022.

Copyright Business Recorder, 2023