The state of indecision can be excruciating particularly when the arguments on both the sides are almost equally forceful. The State Bank was quite happy when the inflation was low, the external sector was performing exceedingly well and the interest rates could be kept low to spur growth rates.
The expansionary monetary stance pursued in the recent past led to record expansion in private sector credit and promoted increased economic activity in almost all the sectors of the economy that yielded GDP growth rate of 6.4 percent in 2003-04 as against 3.1 percent in 2001-02 and 5.1 percent during 2002-03.
Encouraged by the buoyant performance of the last two years, the GDP growth for 2004-05 was targeted at 6.6 percent. It was also promised that "monetary policy will continue to promote an investment orientation" and money supply will be increased to accommodate overall economic growth but prudently managed to obviate higher inflationary trends. The inflation rate for 2004-05 was projected at 5.0 percent.
However, the situation has changed a great deal after unveiling of the budget and annual plan when these projections were presented to the nation.
The most unwelcome development is the recent alarming statistics on inflation, which show that low interest rates and high liquidity growth in the economy have finally begun to show their effect in the form of rapid price increases.
This would of course necessitate an upward adjustment in the interest rate structure so as to contain money supply within reasonable limits and soften price pressures in the economy.
The State Bank has been hinting at such a possibility through various policy statements and at times cautioning the senior management of the banks to be mindful of this as a rise in interest rates would be a logical follow-through consequence of the unfolding events.
While interest rate hike appears inevitable (exact increase would though depend on a number of factors), it has far-reaching consequences for all the stakeholders in the field.
First of all, banks are going to be hit hard. They were riding high on the back of record profits in 2003, which were mainly attributable to low rates of interest and capital gains on PIBs.
The unfortunate aspect, however, was that banks after booking substantial gains by selling PIBs began buying them back at inflated prices due to low T-bill rates and apprehending that interest rates would not go up.
Such a policy is evident from the build-up of PIB holdings in their portfolios. Obviously, a rise in interest rates would erode the value of their portfolios and force the banks to book losses.
This would lower the profits of the banks and may reduce their capital adequacy. It would also limit their ability to extend credit. There are methods to shore up the capital of the banks in such a scenario but every method has a cost attached to it.
The fiscal cost of increase in the rates on government paper can not also be overlooked. Servicing of domestic debt during 2004-05 has been projected to rise by only 5.3 percent to Rs 170.2 billion from Rs 161.5 billion in the revised estimate for 2003-04.
It is quite obvious that the increase could be much higher if sufficient hike in the interest rate is allowed during the course of the current year.
Added to this would be a substantial reduction in petroleum development levy because of government's efforts to keep the domestic POL prices stable in the face of soaring international prices of oil.
These two items could disturb the budget calculations adversely and would have long-term negative consequences. Growth prospects, it may be argued, can also be adversely affected by increase in interest rates.
Stock prices can tumble which may erode the capital of banks. It is quite obvious that the policy planners in Islamabad would like to use their influence to keep the interest rates down for these reasons.
Though these arguments may be valid to an extent, we would urge the State Bank to be resolute and not to be unduly influenced by the demands of various interest groups. It must be remembered that to keep inflation in check is one of its foremost duties and no instrument at its command should be spared to achieve this objective.
All other objectives are secondary in importance from central bank's perspective. Inflation puts a disproportionately higher burden on the common man who is least interested in rosy statistics churned out by the government at the aggregate level.
Besides, it may be pointed out that the argument that low interest rates would lead to higher growth rates is not always correct. Acceleration in inflation beyond a certain limit would have a highly negative impact on growth even if interest rates are kept low because of the impending uncertainty.
Keeping all the factors in view, it would be advisable for the State Bank to let the market forces play their role and make use of its autonomous status to tackle the inflationary threat as a first priority even if it means the issuance of its own paper.