The statement from Dr. Murtaza Syed, Acting Governor the SBP (State Bank of Pakistan) that monetary policy ‘will not risk creating economic recession to bring inflation down and real positive interest rate can be achieved in the longer run’ is a significant step in the right direction. With headline inflation racing rapidly and projected by SBP to remain as high as 18% to 20% in the current fiscal year, markets were concerned that further policy tightening could lead to an economic recession.
The global economy is going through a period of extreme turbulence with international commodity prices at record high levels and the prospects of another global recession staring down at us in 2022/2023. Pakistan, like other emerging economies, is facing severe headwinds with rising inflation and a sharp slowdown in economic activity. Headline inflation has accelerated sharply to 25% in July, with SPI at ~39%, from 8.4% in the same period last year.
There are clear signs of slowing down of the economy which is surely a concerning prognosis for an economy with a young and growing population. Consequently, the rise in poverty and unemployment could lead to social and political turmoil. The standard text book prescriptions, which may perhaps be employed in majority of the countries across the globe, used by our policymakers to deal with similar economic challenges in the past have not yielded desired results and may warrant a shift.
Every country has its own peculiarities and requires bespoke solutions based on ground realities. One-size-fits-all concept is surely not suitable for the complex countries like Pakistan. In today’s article, I want to highlight alternative solutions on managing the monetary policy. Inflation is now the primary objective of SBP, after the passage of the amendments to the SBP Act 2022, earlier the SBP had dual objectives of monetary stability and growth.
However, till date the SBP has no defined inflation targeting mechanism, at least nothing has been shared with the public. The current monetary and exchange rate frameworks, both key anchors for managing inflation and achieving the primary objective are vague with no explicitly defined targets. According to SBP, the current monetary policy is an ‘inflation targeting lite regime’. Instead, SBP uses an ‘inflation forecast range’.
For example, during the last fiscal year, SBP had to change its inflation forecast range three times. At the start of the fiscal year July the target was 7% to 9%, it was later revised in December to 9% to 11% and then in May the inflation forecast was again raised to ‘slightly higher than 11%’.
The lack of an anchor to manage inflation expectations leads to volatility in the market, and the market charges a higher premium to the borrowers. The cost of borrowing for the government on the short-term paper (3 months T-bill) is currently 15.6%, a premium of 60bps above the policy rate 15%. Earlier, the premium was as high as 150bps. According to SBP Working Paper 2020 titled ‘Estimation of Medium Term Inflation Target for Pakistan’, the recommended inflation target range is 5% to 7%. This is based on historical trends and lessons from other emerging economies. However, data for the last 10 years shows that headline inflation has overshot or undershot the inflation target range of 5% to 7% in seven out of the last ten years. On the other hand, core inflation (non food and non energy) has ended within the inflation target range eight times in the last ten years.
By definition, core inflation index is more stable than the headline inflation index as it excludes the high volatility commodities including energy and food items from the basket, which is particularly more pronounced in the recent times with the prevailing commodity super cycle and supply chain issues in the wake of the Russia-Ukraine war.
According to the Central Bank of Canada, headline measures of inflation are inherently noisy (due to one off or temporary supply shocks) and often do not reflect changes in the underlying rate of inflation, the rate at which headline inflation is likely to settle and that monetary policy can affect.
Although monetary policy is capable of controlling overall inflation in the long run, it does not have the ability to control relative price movements such as those for food and energy. We must reconcile to the fact that monetary measures alone cannot fix economic challenges in totality; they can only support fiscal and structural reforms which are the real tools to address economic issues.
The fact is that fiscal and structural reforms could be targeted; however, monetary measures are secular in nature, therefore, they must not be used in isolation and handled with extreme care with most suitable pegging with more stable inflationary number. Measures of core inflation attempt to strip out or smooth volatile changes in particular prices to distinguish the inflation signal from the transitory noise. Thus, relative to changes in headline inflation measures, changes in core measures are much less likely to be reversed, provide a clearer picture of the underlying inflationary pressures, and so serve as a better guide to where headline inflation itself is heading.
Most importantly, if anything which has a real impact of monetary actions is core inflation; headline inflation largely remains out of bounds, particularly in our case where utility prices, food support prices, etc., remain administratively managed. Therefore, when headline inflation has an important transitory component, a focus on core measures can help avoid monetary policy mistakes.
The focus on core instead of headline inflation—and clear communication with the public about that focus—can have another benefit that it may help anchor inflation expectations when headline inflation increases temporarily but core inflation remains essentially unchanged. If the public understands that the central bank is using core inflation in formulating monetary policy, they will realize that the central bank does not need to respond aggressively to a surge in headline inflation (due to imported inflation or tinkering with administrative prices for political reasons or otherwise) to keep inflation under control; thus, provide more certainty and calm to the market. Thus, the advantages of moving towards an inflation targeting framework focused on core inflation will benefit the economy more on a holistic manner.
Markets will have greater transparency and confidence on the SBP policy actions. The government borrowing costs will come down as the premium between the policy rate and T-bill rates will decline, which is one of the fundamental catalyst for fuelling inflation in the economy. This is a perfect time to move towards this direction given the fact that the gap between headline and core inflation numbers is perhaps the widest, with headline inflation of 25% – which is more than double the core inflation of 12%. The gap between the two measures reflects the higher commodity prices impact with higher administrative prices and imported inflation. Therefore, chasing the headline inflation numbers for determining the policy rates to achieve the desired results maybe an overkill, as the Acting Governor also alluded to in his recent statement. This was something that I had always advocated when I was involved in the monetary policy decisions as a member of the Board of Directors of the State Bank of Pakistan for over three and a half years between 2013-2016 and this approach produced the optimal results for the economy overall.
