The demon of inflation seems to be raising its head once again. This critical macro-economic issue had assumed alarming proportions between 1990-91 and 1996-97 when the inflation rate as measured by Consumer Price Index (CPI) ranged between 9.8 percent and 13.0 percent.
There was general agreement that lax fiscal management resulting in excessive growth in money supply was mainly responsible for this situation although supply side bottlenecks, upward adjustment in government administered prices, the imported inflation (pass through of exchange rate adjustment), escalation in indirect taxes and inflationary expectations also played their part.
Subsequently, however, inflationary pressures diminished with the CPI going down almost consistently from 7.8 percent in 1997-98 to 3.1 percent by 2002-03. The achievement during 2002-03 was even better than the target of 4.0 percent fixed for the year.
Economic policy makers of the country attributed this happy development to prudent fiscal management, tight monetary policy and improved supply of food items.
The situation on this front during the current fiscal, though not alarming so far, should nonetheless be a cause of concern for the policy makers. Inflation target was fixed at 3.9 percent but the developments during the year are discouraging.
According to the second quarterly report of the State Bank, in contrast to the downtrend visible in the corresponding periods in recent years, the end-December 2003 marginal inflation rates rose higher than the corresponding figures for December 2002. This applied to all the price indices viz. CPI, Wholesale Price Index (WPI), and Sensitive Price Index (SPI).
In light of these developments, State Bank revised the inflation forecast to range between 3.6 percent and 4.2 percent.
Latest evidence, however, suggests that inflation rate could be substantially higher than this.
In April, 2004, CPI, SPI and WPI were up by 5.99 percent, 8.44 percent and 10.3 percent respectively over their level a year ago.
The trend of higher inflation would be further reinforced by large price increases of petroleum products announced recently.
Increased cost of production, higher transportation charges and a steady increase in the price of essential items are indications of more bad news to come.
To ensure price stability is the responsibility of the central banks all over the world. This is so because expansion in liquidity has a pervasive effect on inflation and the central banks are vested with the power to control liquidity in the economy through a variety of credit control instruments at their disposal.
In Pakistan, the State Bank undertakes this job through a comprehensive annual credit plan exercise which targets monetary expansion in a given year after taking into account factors like growth and inflation targets.
Although ordinary people would be wondering about the causes of recent upsurge in prices, this was not a great mystery for the knowledgeable quarters. Actual increase in money supply during the last two years was much larger than the rise in the availability's of goods and services in the economy and surpassed the targets fixed in the credit plan.
While availability's as measured by the growth of GNP rose by 4.3 percent and 8.4 percent during 2001-02 and 2002-03, increase in monetary assets (M2) amounted to 15.4 percent and 18.0 percent respectively.
The difference between the two aggregates would be even larger if GDP growth figures were used to measure availability's.
Another adverse factor for price stability was an exceptional reserve money growth during 2002-03. While subdued inflationary pressures allowed the State Bank to pursue an expansionary monetary stance during the last two years, it was evident that such a policy stance may have to be revised.
In the annual report for 2002-03, it was recognised by the State Bank that such increases (in M2 and reserve money) were unlikely to be sustained in the months ahead, unless forced by an unwarranted jump in interest rates.
The sad fact is that despite such a realisation on the part of the State Bank, expansionary monetary stance continues to be followed, with the interest rates fluctuating at very low levels and higher than the targeted growth in liquidity in the economy.
Monetary assets during 2003-04 were targeted to increases by 11.0 percent by the State Bank and 10.56 percent by the IMF but actual growth by 10th April, 2004 had reached 13.16 percent.
Also important was the deviation of the causative factors impacting the growth of money supply. For instance, in the credit plan for 2003-04 net budgetary borrowings were expected to grow by Rs 15.0 billion.
Upto April 10, 2004, these had increased by Rs 54.0 billion or more than triple the amount envisaged in the credit plan. Credit to the private sector jumped by Rs 244 billion as against only Rs 85.0 billion projected for the whole year. Impact of other items was contractionary to the extent of Rs 21.3 billion compared with Rs 1.6 billion estimated by the State Bank.
Foreign assets were expansionary by only Rs 56.2 billion as against Rs 130.0 billion projected for the full year.
Such large deviations from the plan targets indicate to a certain extent the inability of the State Bank to project the behaviour of major aggregates with a reasonable degree of certainty. It is interesting that despite major deviations from the original credit plan no major revisions were made in the annual credit plan in the NCCC mid-year meeting.
The State Bank, however, promised at the end of the working paper that it "will be very vigilant of the developments and will ensure that the price stability is not threatened."
It may be mentioned that State Bank has been talking about such a promise in its recent documents. In its first quarterly report for the year 2003-04, an assurance was given that "if the acceleration in CPI inflation continues through December, 2003 and beyond, the monetary stance may need to be re-aligned accordingly."
This was reiterated in the second quarterly report by promising that "SBP continues to closely monitor price trends and stands ready to respond aggressively to contain any surge in inflation beyond tolerable limits."
The boundaries of "tolerable limits" were, however, left undefined. It is clear that the State Bank has been hinting at the possibility of realignment of monetary policy for the last one year or so but strangely no major decision in this regard has been taken so far.
It seems to be hesitant to tighten the monetary stance to decelerate the rate of inflation because of the apprehension of negative consequences of a hike in interest rates on growth prospects.
The lack of clear-cut direction is evident from a timid approach in the conduct of open market operations.
The change in the rates on TBs and PIBs and the amount raised in the auctions to squeeze liquidity from the banks has so far not succeeded in convincing the money market that monetary authorities are serious to increase the interest rates to a level which would dampen the emerging price pressures in the economy.
The reasons for hesitant behaviour of the State Bank could only be guessed. It seems to believe that a premature tightening of monetary policy could choke off growth in the economy.
It also seems to be convinced that factors other than rapid monetary expansion are presently exerting an upward pressure on prices.
For instance, in the second quarterly report, it was observed that the upsurge in food inflation appears to be driven by supply shocks as well as less than adroit management of the agri-product supply chain.
However, this could only be partly true. Yes, there could be trade-off between growth and monetary policy squeeze but only to a certain extent. If monetary policy is too accommodative to spur unreasonable price pressures, the growth prospects could even be jeopardised.
Also, monetary expansion beyond the prescribed targets could only be free of inflationary impact for a short period.
In Pakistan, such a phenomenon has been happening almost for the last three years and this is bound to show up in acceleration in the rate of inflation. A close relationship between monetary expansion and inflation is not only intuitive but has been proved time and again.
According to a comprehensive study on "Determinants of Inflation in Pakistan" conducted by Dr Anjum Nasim under the auspices of State Bank, "a one unit increase in monetary growth results in 0.27 unit increase in the CPI measure of inflation in the current period and 0.28 unit increase in the GDP measure of inflation after a one period lag... The long run impact of a one percent increase in money supply is about 0.45 percent increase in both the GDP deflator and in the CPI." In other words, almost one half of the increase in prices could be directly attributed to monetary expansion in the economy.
The expansion in monetary assets could cause even higher inflation if increase is concentrated in currency in circulation which has shot up by nearly 21 percent in the current year while deposit money has gone up only by about 11 percent.
The imminent price pressures originating from excessive doses of liquidity could cause a lot of problems for the economy.
Uncertainty about the purchasing power of the rupee could adversely influence saving and investment decisions and growth prospects as well as exchange rate and flow of money across the borders.
Inflation could also aggravate income inequalities and render the deprived sections of the society even poorer. Such an impact should be particularly worrying for a country like Pakistan where more than one third of the population is already living below the poverty line and whatever income they are able to receive is spent on food.
According to a study by Sajjad Akhtar, one percent increase in food price inflation increases poverty by 0.5 percent ie, a five percent food price inflation this year is likely to raise poverty by 2.5 percent.
The possibility of such an explosive situation needs to be checked by resorting to stringent monetary policy as soon as possible. It may be advisable to let the TB and PIB rates rise to the Bank Rate level of 7.5 percent within the next two or three months.
Present policy of the State Bank to increase the rates only marginally would not be very helpful in keeping a proper lid on the price level.
Of course the suggested course would increase debt servicing obligations of the government and create some disillusion in the business circles but it needs to be pointed out that in the last few years these circles have been pampered at the cost of depositors who have been getting negative returns.
For the sake of equity and to mobilise higher level of savings, a fair deal to the depositors needs to be ensured.
Also, higher interest rates would check the growing consumerism in the society which is financed by easy bank loans.
Such a trend may be good for the developed countries but could be harmful for our country on a long-term basis.
Pakistan has faced the consequences of living beyond means. Besides, tightening of monetary policy would discourage hoarding of essential commodities.
In the second quarterly report, the State Bank has itself observed that "the resulting fall in carrying costs have reduced an important constraint on speculative activities."
However, the most pressing requirement continues to be the maintenance of price stability which in the last few years had provided a measure of solace to the ordinary people of Pakistan against heavy odds and this can only be ensured through a bolder approach on the part of monetary authorities.