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INTRODUCTION There is a serious threat that the Pakistan economy could get entrenched into a prolonged and deep stagflation unless decisive and concerted action is taken by policy makers. There are clear signs that at least in the foreseeable future the economy will witness low economic growth and high double digit inflation - the classical characteristics of an economy in stagflation. The real challenge therefore is to draw up a co-ordinated strategic response to break out of stagflation by rekindling growth and checking inflation. Regaining macroeconomic stability must remain of paramount importance as it is essential for ensuring sustained growth. Yet it is important to emphasize that in the current troubled socio-economic milieu economic growth that creates new jobs and reduces poverty is equally vital not just for the economy but indeed the country. It is in this context that PIDE’s Monetary Policy Viewpoint analyzes the latest September 29, 2010 State Bank Monetary Policy Statement in which it announced an increase in the discount rate by 50 basis points to 13.5 percent from 13 percent for the second time this year.
MONETARY POLICY STATEMENT (OCTOBER-NOVEMBER 2010) Monetary policy management is one of the primary roles of the State Bank of Pakistan (SBP). In line with SBP Act, monetary policy has to be supportive of the dual objective of promoting economic growth and price stability. The SBP conducts monetary policy by using money supply (M2) as an intermediate target. This target is set with the help of real GDP growth and inflation targets set by the Government. In its Monetary Policy Statement the State Bank highlights the following recent economic developments which pose a serious risk in attaining macroeconomic stability: High fiscal deficit resulting from increased government spending which would further heighten inflationary pressures. Floods have further worsened this situation. Trade balance could come under stress. Rise in Non Performing Loans (NPLs) of the private sector and expected increased borrowing of the government. Moreover, Monetary Policy Statement points to a number of factors that could raise inflationary expectations. These include disruptions caused by catastrophic floods,
The viewpoint was produced by a PIDE team led by Dr. Abdul Qayyum and included Mr. Muhammad Javed and Mr. Kashif Munir.
Khan & Khwaja (2007)] that interest rate influences inflation with a lag of 12 to 18 months and the magnitude of this impact is very small. and second. in Pakistan (and indeed in most developing countries) monetary policy actions transmit their effects on macroeconomic variables with a considerable lag and with a high degree of volatility and uncertainty. 2007) show that the relationship between interest rate and inflation is positive. It implies that rising interest rate in recent years has little impact on dampening inflation and there is no reason to believe that the situation has now changed. The SBP sets a target of M2 growth in line with government’s targets of inflation and growth. There is clear evidence based on empirical analysis [see Khan and Qayyum (2007). PIDE’S VIEW ON MONETARY POLICY DECISION Currently SBP is using interest rate as an instrument of monetary policy to control inflation. This brings to fore the question of the effectiveness of the interest rate channel as a transmission mechanism. The SBP pursues a monetary target regime with broad money supply (M2) as a nominal anchor to achieve the objective of price stability. Indeed some studies (e. However. The coefficient of correlation is 0.g. the SBP can control growth in M2. Qayyum. Effectiveness of Interest Rate Channel Since 2005 monetary policy has mainly relied on interest rate channel. 2 . introduction of the reformed GST and continued reliance of the government on borrowings from the SBP.expected increase in electricity prices. Khan. there is a strong and reliable relationship between the goal variable (inflation or real GDP) and M2.5 percent. It suggests a positive relationship between the interest rate and inflation although clearly a number of other factors were at play. This framework is based on two key assumptions: first. The current monetary policy stance is silent about the issues of lags and the pass-through effect of the policy rate to inflation.688. The movements of interest rate and inflation between 2007-10 can be depicted in figure 1. It is in light of the above mentioned facts that SBP has increased the discount rate by 50 basis points to 13.
The increase in interest rate would increase interest payments on government debt which will cause an even higher fiscal deficit even if we take into account higher profits of the State Bank. The truth is that the government is borrowing beyond the agreed level from the SBP. and the SBP is not able to restrain this level of borrowing. During 2008-09 the increase in discount rate increased the cost of borrowing from Treasury Bill. In this period an amount of Rs 580 billion was spent on account of servicing of domestic debt against the budgeted estimates of Rs 459. 3 . The fact is that easy recourse to increased borrowings from the SBP leaves little incentive to the government to put its badly needed fiscal situation in order.1 billion.Figure 1: Movements of inflation and interest rate Interest Rate and Fiscal Deficit Let us now examine whether the increase in interest rate would act as a deterrent to increased government borrowings from SBP as the recent Monetary Policy Statement appears to argue. The impact therefore of a tight monetary policy stance is diluted with this automatic creation of money which increases the money supply. And in this situation an increase in interest rate can further worsen rather than improve the situation. In fact it could further worsen the situation. Borrowing from the SBP injects liquidity in the system through increased currency in circulation. Pakistan Investment Bond rate and National Savings Scheme. The likelihood then is that the government would finance the higher deficit on account of higher interest payment by borrowing further from the central bank.
5 percent to 13 percent which is again negatively affecting the credit to private sector as can be seen in Figure: 2. When the demand for private sector credit decreases.Monetary Policy and Real GDP Growth If the increase in the interest rate neither helps to reduce inflation nor appears to act as a deterrent to government borrowing then the real hit is taken by the private sector. Higher interest rate increases the cost of borrowing of the private sector which discourages the demand for private sector credit. Figure 2: Interest Rate and Credit to Private Sector Exchange Rate If in the current situation increase in interest rate is neither slowing inflation nor curbing government expenditure but just slowing down the private sector the only possible reason not made explicit by the SBP in its Policy Statement is that this measure could help stabilize the exchange rate.5 percent in November 2009. the Monetary authority again tightened monetary policy by increasing the policy rate by 50 basis point from 12.84 over the period August 2009 to August 2010). credit to private sector increased gradually during this period. When the Monetary authority reduced policy rate by 100 basis point from 14 percent to 13 percent in August 2009 and then further to 12. In August 2010. 4 . Monetary Policy and Credit to Private Sector There is a strong negative correlation between discount rate and credit to the private sector (-0. the level of private investment falls which adversely affects economic growth.
It is now well established that it is not possible to achieve simultaneously exchange rate stability. In any case exchange rate policy should be determined by the country’s competitiveness rather than artificially propped up through higher interest rates. Sajawal (2007). 14.Here it is important to make a clear distinction between exchange rate management and monetary policy management. The Pakistan Development Review. Economic Analysis Working Papers. What is needed is an integrated fiscal cum monetary response which brings about macroeconomic stability and helps spur much needed growth into the economy. “Interest Rate Pass-through in Pakistan: Evidence from transfer Function Approach”. pp. Idrees (2005). Khan. “Trade. Qayyum. What we have argued is that a tight monetary policy stance through increase in the discount rate serves little purpose in the current conditions. Also fiscal reforms are easier to undertake and yield desired results in a growth promoting rather than a depressed economic environment. 6. Financial and Growth Nexus in Pakistan”. monetary independence and free movement of capital (the so-called “Impossible Trinity”). Vol. “Channels and Lags In Effects of Monetary Policy’s Transmission Mechanism: A Case of Pakistan”. Indeed. Trying to stabilize the exchange rate would mean a loss of monetary policy autonomy even if in the very short-term high interest rates may prevent movement from local to foreign currencies. Islamabad). Unpublished Ph. Vol. No. A. REFERENCES Khan. Arshad and A. CONCLUSION The strong message of the SBP through its latest Monetary Policy Statement for Pakistan to put its fiscal house in order must clearly be supported. 5 . 44.D Dissertation (Pakistan Institute of Development Economics. 4. 975-1001. Sajawal Khan and Khawaja M. it only further squeezes the private sector and discourages private investment which is already facing an extremely difficult situation. Qayyum (2007). No. M.
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