5
Money and Banking
5.1 Monetary Policy
As in the previous year, the SBP continued tomaintain a tight monetary policy throughoutFY06, even though the principal policyvariable, the discount rate remainedunchanged at 9.0 percent during the period, incontrast to the 150 basis point rise seen inFY05. Instead, during FY06 the SBP focusedessentially on improving the transmission of the policy rate, by draining excess liquidityfrom the inter-bank market and driving theovernight repo rates very close to the discountrate
1
(see
Table 5.1
). This approach proved tobe very effective.The impact of the improvement in thetransmission channel from the policy rates tothe retail rates is clearly evident in the sharpdeceleration of major monetary aggregates, and the lower growth in private sector credit during FY06.Although the overall money supply growth for the year reached well above the 12.8 percent target, itwas nonetheless significantly lower than the growth witnessed in FY05 (see
Table
5.2
). The fall inreserve money growth was even steeper. Similarly, the growth in credit to the private sector slowedvery sharply, even though it exceeded the initial target.As a result during FY06, for the first time in 6 years, the growth in broad money dropped below that
1
This was because throughout H1-FY05, there was little evidence of a rise in lending rates in response to relatively sharperincrease in 6-month repo rate. However, H2-FY05 onwards, the lending rates started responding due to the increase in SBPliquidity absorptions through OMOs. The objective of FY06 monetary stance was to sustain this trend.
Table 5.1: SBP Monetary TighteningFY05 FY06
Number of OMOs 51 92Number of absorptions 46 62Number of injections 5 30Average overnight repo rate 3.8 7.9Coefficient of variation 0.6 0.1
Table 5.2: Key Macro Targets and Performance
growth in percent
FY05 FY06Targets Actual
TargetsProvisionalestimates
GDP 6.6 8.6 7.0 6.6Inflation 5.0 9.3 8.0 7.9M2 14.5 19.3 12.8 15.2Reserve money - 17.6 - 10.2Private credit - 34.4 - 23.5
024681012
J u l - 0 3 S e p - 0 3 N o v - 0 3 J a n - 0 4 M a r - 0 4 M a y - 0 4 J u l - 0 4 S e p - 0 4 N o v - 0 4 J a n - 0 5 M a r - 0 5 M a y - 0 5 J u l - 0 5 S e p - 0 5 N o v - 0 5 J a n - 0 6 M a r - 0 6 M a y - 0 6 J u l - 0 6 p e r c e n t
18222630343842
Y o Y g r o w t h
CPI Inflation6m RepoSBP repo rateNFNE* Private sector credit (rhs)
Figure 5.1: Key Monetary Indicators
Gradual tightening against alow non-food non-energyinflationAggressive tightening asthe inflation (general &core) grows unabatedTight monetaryposture mainlythrough moneymarketinterventions*NFNE: Non-food non-energy inflation
State Bank of Pakistan Annual Report for 2005-06
88
of nominal GDP. Thus, it can be argued that the tight monetary policy was one of the significantfactors in lowering inflationary pressures in the economy by reducing aggregate demand. This issuggested not only in the fall in average annual CPI inflation from 9.3 percent in FY05 to 7.9 percentin FY06, but also by the gradual deceleration in core inflation seen through FY06 (see
Figure 5.1
).The impact of the monetary tightening is visible through most of the fiscal year, as monetary growthhas continued to fall lower than that of the preceding year, in most months (see
Figure 5.2
). Onlyduring the peak lending period of the credit cycle, the normal seasonal money demand has been
stronger
than in FY05.
2
On the whole therefore, it would appear thatthe central bank was successful in modulatingmonetary policy to contain inflation withinthe 8.0 percent annual target, withoutprejudice to the country’s long term growthmomentum. However, as in the previousyear, the continued tight monetary policyattracted considerable debate, with somecalling for a reversal of the policy in order tosupport a perceived faltering domesticdemand and slowing exports; while otherscontinue to argue that monetary policy has notdone enough. In fact, proponents of the latterview insisted that monetary tightening shouldhave been greater in FY06, with a further hike in policy rate, complemented by a depreciation of theRupee.However, the evidence for a serious slowdown in the broader economy is scanty. A look at
Figure5.3
shows that despite the sharp deceleration, monetary growth during FY06 was amongst the highestin the last 15 years, relative to the growth in nominal GDP. Moreover, while inflation has certainlydeclined significantly, it should be kept in mind that the 7.9 percent average CPI inflation for FY06remains high, and that the deceleration in core inflation in the same period has been modest.Similarly, the exceptional growth in the country’s imports indicates that demand pressures are stillquite strong in the economy.Why then didn’t the central bank significantlyraise its policy rate? Quite simply, this wasbecause SBP forecasts indicated thelikelihood that monetary tightening wasadequate to achieve the target inflation rate,and because it was anticipated that theexceptional import growth would moderatesignificantly by H2-FY06. The decision fornot raising the policy rate was further guidedby the following:(1)
In the initial years of the currentdecade, the focus on monetary policy
2
It is important to see that the money supply growth during the 2
nd
quarter (period of seasonal off take) has on averageremained larger in FY06 at 3.1 percent compared with 2.8 percent during FY05. This suggests that the SBP stance of controlling inflation without a significant derailing of the growth momentum was effective.
222732374247FY91FY93FY95FY97FY99FY01FY03FY05
Figure 5.3: Money Supply (as percent of GDP)
-4.5-3.6-2.7-1.8-0.90.0
J u l A u g S e p O c t N o v D e c J a n F e b M a r A p r M a y J u n p e r c e n t a g e p o i n t s
Difference b/w FY06 & FY05Unusually high seasonal demand
Figure 5.2: M2 Growth - Impact of Monetary Policy
Money and Banking
89had been greater on reviving economic growth rather than containing inflation. While thisfocus reverted to reducing inflation FY05 onwards, there was a conscious decision to lowerinflationary pressures
gradually
over a longer time (2-3 years), since attempts to hasten thepace of disinflation ran the risk of destabilizing the growth momentum of the economy.Thus, the targeted inflation reduction in FY06 was a very modest 1.3 percentage points.(2)
Moreover, recent research findings indicated that a significant impact of monetary tighteningon reducing inflation persists over almost 28 months. Thus, monetary tightening duringFY06 had to encompass both, the impact of the improvement in transmission of changes inpolicy rate, as well as the lagged impact of the hike in policy rates during FY05 (see
Box5.1
) on output and inflation in FY06. It was felt that the impact of aggressive policy rateincreases in FY06 would have been exaggerated by the lagged impact of earlier tightening,raising the risk of an economic slowdown.
Box 5.1: The lags involved in monetary policy transmission in Pakistan
Only a few studies have been conducted in Pakistan that have empirically estimated the relative strength of various channelsthrough which the monetary policy transmits to the ultimate objectives of growth and inflation. As such, the lags that areinvolved in transmission mechanism have also rarely been quantified. In this perspective, recent research at the SBPprovides useful insights on the response of the economy to a tightening of monetary policy.The estimation in the study has been done on monthly data from July 1996 to March 2004 using 6 months as optimal laglength in all of the VAR system. The study has concluded that during the first 6 months of a monetary shock, the aggregateprice level responds very little. However, 6 months onwards, the price level
declines persistently. In sharp contrast to this,the output responds very quickly and bottoms out after 7 months; later which it dissipates (see
Figure 5.1.1
).Another recent finding is the Khan and Schimmelpfennig (2005) which has attempted to figure out whether or not theinflation is a monetary phenomenon in Pakistan. Using the monthly data covering the period from January 1998 to June2005, they concluded that the inflation is found to be a monetary phenomenon caused mainly by the growth in money supplyand credit to private sector. According to their estimates, there is a lag of about 12 months, within which the broad moneygrowth and the private sector credit explains the inflation developments
.
References:
(1)
Khan, Mohsin and Schimmelpfennig, Axel; Money or Wheat, SBP Research Bulletin, Vol.2, Number 1, 2006..(2)
Mubarik, Yasir Ali, Agha, Asif Idrees, Ahmed, Noor and Shah, Hastam, Transmission mechanism of monetarypolicy, SBP Working Paper no. 09 dated 2004.
Response of IPI to Changes in 6m T-bill
-0.020-0.0100.0000.010147101316192225283134months-0.006-0.0020.0020.006147101316192225283134months
Response of Price to Changes in 6m T-billFigure 5.1.1: Impulse Response Function
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