The International Monetary Fund (IMF) said that more than five percent inflation may hamper economic and financial growth by arguing that monetary factors are the main drivers of inflation in Pakistan.
It recommends five percent threshold level of inflation for economic growth beyond which the inflation is 'inimical to economic growth and financial development.'
The IMF working paper 'Inflation in Pakistan money or wheat?' suggests that for higher inflation the responsible factor is the "money"!
The Fund believes that inflation in Pakistan is a monetary phenomenon, it is the responsibility of the State Bank of Pakistan (SBP) and the monetary authorities to achieve price stability.
The empirical results show that monetary factors determine inflation in Pakistan, whereas broad money and private sector credit growth are the key variables that explain increment in inflation with a lag of around 12 months, it added.
The working paper was authored by Mohsin S. Khan and Axel Schimmelpfenning. However, the views expressed are those of the authors and not necessarily those of the IMF.
The working paper might be useful for policy-makers in setting inflation target but the issue needs to be further researched, particularly to see what level of inflation is too low to promote economic growth.
The economic managers of the government expected that inflation during the current fiscal year at around 8 percent with an economic growth of 7 percent. In eight months of the current fiscal (July-February 2005-06), inflation rose by 8.42 percent, down from 8.91 percent in the same period last year.
They suggest that the SBP should first and foremost focus its policies on keeping inflation close to its target of five percent. The SBP, in principle, could also target an exchange rate level as a nominal anchor to achieve macroeconomic stability.
In addition, the exchange rate would no longer be available to offset the impact of external shocks on the domestic economy, the paper said.
It also said that a long-run relationship exists between the CPI and the private sector credit. The wheat support price impacts inflation in the short-run, but not in the long-run.
Pakistan's growth record since 1970s underscore that high and persistent inflation is harmful to growth. Periods of high inflation have coincided with low growth spells, while high growth episodes tend to be associated with a low inflation environment.
Price stability can be approximated by different metrics. While headline inflation is better understood by the public, it is often argued that monetary policy should be more concerned with core inflation.
Given the volatility of some components of the CPI, in particular food prices and energy prices, core inflation (approximated as non-food, non-energy or the SBP's trimmed mean definition) is a better measure of underlying inflationary trends than headline inflation.
Nonetheless, headline inflation is better understood by the public and affects households immediately. Taken together, core inflation is the right target for monetary policy, in particular over the medium term, but the SBP also needs to keep a watchful eye on headline inflation, they proposed.
After remaining relatively low for quite a long time, the inflation rate in Pakistan accelerated starting from late 2003. Following the 1998-99 crisis, the inflation was reduced to below five percent by 2000 and remained stable through 2003. Tight monetary policy (combined with fiscal consolidation) appears to have contributed to this low-inflation environment.
It said that inflation follows broad money growth and the private sector credit growth closely with a lag of about 12 months. With monetary growth picking up, inflation increased sharply in late 2003, peaking at 11 percent year-on-year in April 2005. Average annual inflation appears to have stabilised around 8 to 9 percent by September 2005.
The acceleration of inflation also coincided with two increases in the wheat support price in September 2003 and in September 2004, which has re-opened the debate whether the wheat support price was the main driver of inflation in Pakistan.