The most concerning and alarming element in the macro numbers is that inflation is growing out of control. Food inflation has exceeded 40 percent while the core inflation is close to 20 percent. The question is how to control growing inflation and what can be done through monetary policy. The policy rate is currently at 17 percent while the market rates have increased by 200 basis points, which translates into an effective policy rate of 19 percent. The question is should State Bank of Pakistan (SBP) come up with an emergent meeting to increase the policy rate or wait.
The uptick in inflation is primarily from the supply side. Last year, large swathes of agriculture land were under water due to floods, and that had disrupted the supply of food items and perhaps explained high inflation in perishable items. One reason for high and persistent food inflation in non-perishable items, which could be due to the fact that the demand for food from young and growing population is fast outpacing the growth in grain production.
Then, the currency depreciation and post-Covid global commodity super-cycle amidst the Ukraine war has a role to play in the inflation at home. The generous concessionary refinance facilities by SBP around Covid time resulted in high monetary expansion, which is perhaps due to some misuse of such facilities. The monetary overhang has its contribution to high inflation, as well. And then, the jumps in inflation are due to sudden and large increases in fuel and other energy prices. Some of these have a permanent impact while others have just raised the inflation for 12 months due to base effect.
There is no decent study conducted by SBP or any other organisation to pinpoint the reasons for rising inflation — especially food inflation. One needs to bifurcate the impact of floods and other exogenous factors that may reverse with the change in crop cycles. Then the monetary overhang and its impact on the demand needs to be evaluated. And that must be incorporated with the erosion of purchasing power and demand destruction due to falling real income in the past few quarters. I think it’s high time that SBP uses its battery of economists to come up with a paper on growing food and headline inflation. Moreover, SBP should fill in the vacant position of one deputy governor without any further loss of time.
Without doing so, the efficacy of monetary policy could be limited. The information with the monetary policy external members remains limited to findings of SBP’s black box model. It is time to introspect. These times are unprecedented and need out of the box thinking.
The real question to ask is how well inflation expectations have entrenched. How good is the negotiation power of labor force to increase the wages in line with growing inflation which could create wage-price spiral i.e., wages rising just enough to compensate for higher inflation. Moreover, firms may increase the foods/services prices to keep their margins intact. There are no strong compliance of labour laws in Pakistan, and labour unions are generally weak. This means that increase in wages could not be like inflation. Moreover, unemployment is on the rise which makes the negotiation power of workers weaker.
The other question that needs to be probed is how effective a rise in interest rates can be in countering building inflation expectations? Consumer demand is eroding with an exceptional rise in prices -such as auto finance demand. Private sector credit demand is shrinking due to supply chain disruptions in the aftermath of restrictions on LCs and falling demand.
Growing demand for credit is from the government. And fiscal consolidation is required. Would the monetary tightening help in lowering the government demand for borrowing? Or it is better to tighten fiscal policy more to compensate for having real negative rates? Then the other problem is that some economists and analysts are talking about increase in interest rates and domestic debt restructuring in the same breath whereas debt restructuring is essentially lowering the rates on the existing government bonds.
Some economists are of the view that the increase in interest rates may or may not help in reducing inflation; but having real positive rates would surely help arrest the steady build-up of inflation expectations. That is a valid ask. Then the IMF is in favour of moving towards real positive rates. However, one is required to see the case of Turkey and Sri Lanka where inflation is tapering from a very high levels despite keeping large negative real rates.
Having said that, it is important to note that the market rates are already up and have incorporated the increase in the policy rate by 2 percent. This will now create distortion in the money market where SBP is consistently providing liquidity through open market operations (OMOs) whose rates are linked to the policy rate. That enhances the banks’ margins abnormally and the government is bearing the cost. One way to deal with this is to further tax those margins while the other is to match the market rates. The option of matching the rates is better and that to kill the uncertainty especially when a big treasury bill auction is approaching before the scheduled policy rate.
This makes the case for an emergent monetary policy very strong. SBP should come up with some sort of communication either in the form of emergent monetary policy or some other form sooner than the later and should have a clear forward guidance to help calm the money market. Thus, SBP needs to rise to the occasion by playing the role of a strong and efficient regulator.Ali Khizar, "Should the MPC meeting be preponed?," Business recorder. 2023-02-27.
Keywords: Social sciences , Social policy , Monetary policy , Inflation rate , Policy rate , Global economy , Inflation expectations , SBP