State Bank of Pakistan

Monetary Policy Formulation and

Implementation

Fida Hussain
Economic Policy Review Department
State Bank of Pakistan
LRC, August 7, 2018
 Introduction

Monetary Policy
Committee

Monetary Policy Monetary Policy

Process Monetary Framework/Flexible
Forecasts/Economic Policy Inflation targeting
outlook Framework

Monetary Policy
Instruments/Interest
Rate Corridor

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 Some background!
Evolution of central banking or a central bank

 Central banking originated from Europe;

 Some of the central banks started as government banks to bring order in

issuance of currency:
– Riksbank of Sweden, first central bank to be established in 1668 (also financed
the wars of Age of Liberty);
– Bank of France in 1800 and The Netherland Bank in 1814.
 Some were established to fund government operations, especially to pay off
debt or finance wars:
– Bank of England was established by King William in 1694 to lend to British
government to finance its war against France.
– First Bank of United States was established in 1791 to refinance the war related
debt accumulated by different states; for the same purpose, second Bank of
United States was established in 1816.
 During 20th century, majority were created for central banking functions.

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 Functions of a modern central bank
Transformation of objectives rather than change in functions

Formulate Regulate Foster safe

Issue and
and and and
Primary manage Lender of
implement supervise efficient
Functions national
monetary financial payment
last resort
currency
policy system system

Non-
foreign Advisor and
Secondary Public debt traditional
exchange banker to
Functions management
management government
development
role

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 What is monetary policy?

“Regulation of money supply and interest rate in the economy to

achieve economic goals”

“Way of managing supply of money in the economy”

“Monetary policy involves central banks’ use of policy

instruments to influence interest rates and money supply to
keep overall prices and financial markets stable”

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 Why manage money supply?
To maintain the value of money and promote confidence of
the public to hold domestic currency
 In modern times money is not backed by gold or silver – its fiat
money!;
 Quantity of goods and services one can buy with a certain
amount of money;
 Value of money decreases if same amount of money buys you
less quantity;
 This means prices have gone up – inflation
 Value f money increases if same amount of money buys you
more quantity;
 This means decline in prices - deflation
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 What is objective of monetary policy?
 To control inflation and keep it low – known as price stability;
 An example:
– Suppose person X lends Rs 100 to person Y at an interest rate of 6% for
the year;
– Person Y must return Rs 106 at the year end to person X;
– Both would be happy if there is no inflation;
– If prices increase by 8% then person X gets: [106] – [100(0.08)] = Rs 98:
actually losing Rs2 – here borrower is happy as she is returning less
amount in real terms than what she borrowed;
– What about the lender?
– But, if person X anticipates inflation to be 8% then he might charge a
nominal interest rate of 11%: [111] – [100(0.08)] = 103.

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 Why focus on price Stability?
To avoid costs of high inflation
 High inflation generally coincide with high degree of variability that:
– makes it difficult for the individuals and firms to efficiently plan their decisions
to consume, save and invest;
– discourages investment because when firms are uncertain about future worth
of their money, they become reluctant to invest—low investment reduces
economy’s potential to produce in future;
– creates incentives for households to spend resources to manage inflation risk
i.e. people generally prefer to spend when inflation is rising;
– discourages long term contracts (due to uncertainty) and resources are wasted
on frequent negotiations;
– diverts resources away from efficient production;
– undermines confidence in domestic currency;
– impacts more severely fixed income and low income groups;
– Redistributes wealth from savers to borrowers (mainly business community).

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 Why focus on price stability?
Low and stable inflation helps in achieving other objectives!

 Low and stable inflation facilitate:

– businesses in making sound investment decisions;
– maintaining value of domestic currency;
– protecting savings of the nationals;
 These, in turn, ensure stability in the value of domestic currency and
promote growth and job creation in the economy.
 Thus, price stability is consistent with the “other goals” in the long-run –
there is no trade-off between inflation and employment in the long-run.
 However, there are short-run trade-off – for example, monetary tightening
might help in controlling inflation, but might cause unemployment to rise
in the short-run.

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 What monetary policy can and cannot do?
 Monetary policy plays a central role in reducing inflation and keeping it at
moderate or low levels, broadly termed as price stability;

 An expansionary monetary policy can stimulate economic activity only in the

short run, that is, when actual output is much below potential and inflation is
low.

 There is no trade-off between inflation and growth in long-run.

 Monetary policy has little role in directly increasing country’s capacity to

produce goods and services.

 Monetary policy has a lasting effect on inflation but only a transient effect on
output.

Monetary policy is a stabilization/aggregate demand management policy

and can not impact long-term growth potential.

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 Monetary policy and demand management

i MS

New MS

Md

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 When stabilization policies are needed

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 Stabilization policies at work

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 How to achieve these objectives?

Central Bank

Money supply,
short-term Low inflation,
interest rates high growth

An
intermediate
variable

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How monetary policy works? Monetary transmission mechanism
 Monetary policy affects inflation and economic activity through
adjustment in aggregate demand brought about by changes in interest
rate (or money supply).

 This process is known as transmission mechanism of monetary policy.

 First the changes in policy rate affect interbank and retail interest rates
directly as well as through ‘expectations’.

 The resulting changes in retail interest rates then affects the

consumption and investment behavior of households and businesses
and thus the level of aggregate demand in the economy.

 Finally, the adjustment in aggregate demand affects the general price

level and thus inflation in the economy.

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 Monetary transmission mechanism

Market ineterst
rates
Domestic
demand
Credit
aggregates
Aggregate Inflationary
demand pressures
Policy
rate
Asset prices
External
demand Inflation

Exchange rate Import

prices

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Monetary Policy Formulation and
Implementation in Pakistan

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 Objectives of monetary policy in Pakistan
 The preamble of the SBP (Amendment) Act, 1956 broadly defines monetary
policy objectives:
– ‘whereas it is necessary to provide for the constitution of State Bank to regulate
the monetary and credit system of Pakistan and to foster its growth in the best
national interest with a view to securing monetary stability and fuller utilization
of the country’s productive resources’
 This broad mandate of monetary policy could be interpreted in several ways;
– For example, monetary stability is generally interpreted as price stability;
however, it could also be seen as stabilizing growth in money supply or some
monetary aggregate;
– Similarly, effective regulation of banks guarding against decline in asset quality
and bank runs is generally considered synonymous with soundness of financial
sector, it is now sees as keeping stable conditions in the interbank market.
 SBP focuses on achieving monetary stability by controlling inflation close
to its targets set by the government;
 At the same time, SBP also aims to ensure financial stability, particularly the
smooth functioning of the financial market and the payments system.
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 Monetary policy decision making process
Institutional set-up
 The SBP (Amendment) Act 2015 empowers Monetary Policy Committee
to formulate and implement monetary policy;
 At present, MPC consists of:
– The Governor SBP, as chairperson with Deputy Governor (Policy) in
Governor’s absence;
– Deputy Governor (FMRM & BPRG);
– Chief Economist;
– Executive Director BPRG;
– Three Board members selected amongst themselves;
– Three external experts/economists – Dr. Asad Zaman (PIDE), Dr. Qazi Massod
Ahmed (IBA), and Dr. Aliya Hashmi Khan (QU);
 The MPC meets at least six times a year, in the second week of the
alternate month, to decide monetary policy stance;

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 Monetary policy decision making process
Procedures

Monetary Policy
Committee

Monetary Operations
Committee

Forecasting Committee

Forecasting unit Macroeconomic

Framework
1. Inflation Modeling Unit
1. GDP
2. Output gap Policy Simulation using FPAS
2. Balance of Payments model
3. Trade
3. Monetary
4. Exchange Rate misalignment
4. Fiscal and Public Debt
5. Monetary Aggregates

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 Monetary policy decision-making process
Main considerations

• Assessment of near term inflation

path and inflation expectations vis-a-
Prime vis inflation target
considerations • Growth outlook in case inflation is
expected to remain close to or below
its target

• Assessment of external sector

sustainability
Secondary
• Likely pressures on exchange rate,
considerations which also have implications for
inflation outlook

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 Monetary policy implementation

Operationally, SBP attempt to controlling overnight money market repo rate

close to the SBP Target Rate , the Policy Rate

 Overnight money market repo rate is a weighted average interest rate on

overnight repos against treasury bills/PIBs in the interbank market, with
share of respective transactions in total repos during the day as weight.

– Repo transaction is the spot sale of government securities with

agreement to purchase (forward) the same.

– Reverse repo transaction is the mirror image of the repo transaction i.e.
spot purchase of government securities with the agreement to sell
(forward) the same.

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 Monetary Policy Implementation
Interest Rate Corridor

WA Overnight repo rate SBP reverse repo rate SBP repo rate SBP Policy (Target) rate

16

14

12
percent

10

4
Jul-11

Jul-18
Jun-14
Jun-07

Oct-09

Oct-16

May-17
Mar-09

May-10

Nov-13

Mar-16
Jan-15
Jan-08

Sep-12
Feb-12
Aug-08

Aug-15
Dec-10

Dec-17
Apr-13

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 Monetary policy instruments in Pakistan
 Rates on standing facilities
– SBP reverse repo rate (Discount rate); 8.0 percent per annum; 50 bps above
the SBP Target Rate or the policy rate currently at 7.5 percent;
– SBP repo rate — 150 bps below the SBP Target Rate;
 Open Market Operations
– are conducted regularly on Thursdays and on need basis on other days;
 Cash Reserve Ratio (CRR)
– 5% for demand liabilities (including less than 1 year time deposits) and 0%
for time liabilities of above 1-year tenor;
– 5% as CRR and 15% special CRR on FCY deposits
 Statutory Liquidity Ratio (SLR)
– 19% for demand liabilities (including less than 1 year time deposits) and 0%
for time liabilities of above 1-year tenor;
 Forex Swaps
– Are used depending on the situation in forex market.
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 Monetary policy instruments
 Rates on standing lending/deposit facility
– In case banks fail to raise needed funds from the market, they can approach central
bank, as a last resort, and borrow the needed funds (collateralized or
uncollateralized), and vice versa;
 Open Market Operations (OMOs)
– Central banks inject (drain) liquidity through purchase (sale) of government
securities from (to) commercial banks generally with an agreement of sale
(purchase)—reverse repo (repo);
– Outright sale or purchase of T-bills (in case market is expected to remain long or
short over longer period).

 Forex swaps
– Swaps are similar to repo operations described above;
– Purchase of dollars results in injection of Pak rupees, while selling of dollars drains
Rupee liquidity.
– Transactions impact liquidity in both money and foreign exchange markets
simultaneously;
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Pakistan’s Recent Monetary Policy Experiences

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 Macroeconomic environment
Inflation has remained below the target for the last four years; but inched up recently

Consumer Price Inflation (percent YoY)

Average CPI Inflation (percent)
Actual Target Headline Food NFNE 20% Trimmed
21.0 35.0

30.0
18.0
25.0
15.0
12.0 20.0
12.0 11.0
9.5 15.0
9.0 8.0 9.0 9.5
8.0 10.0
6.5 6.5
6.0 6.0 6.0 6.0
6.0
5.0 5.0

3.0 0.0

0.0 -5.0
FY07
FY08

FY12
FY13
FY14

FY18
FY05
FY06

FY09
FY10
FY11

FY15
FY16
FY17

Jan-06
Jul-06

Jan-15
Jul-07
Jul-08
Jul-09
Jan-10
Jul-10
Jan-11
Jul-11
Jan-12
Jul-12
Jul-13
Jul-14
Jul-15
Jan-16
Jul-16
Jan-17
Jul-17
Jul-18
Jan-07
Jan-08
Jan-09

Jan-13
Jan-14

Jan-18
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 Macroeconomic environment
Weak real economic activity before getting some pace in FY17 and FY18

Real GDP Growth (percent) Growth in LSM

Actual Target (12 month moving average)
8.0 25.0
7.0 7.0 7.2
7.0
20.0
6.6
6.0 5.5 6.0
5.7 15.0
5.5
5.0 5.1
4.5 4.2 4.3
4.4
10.0
4.0
3.3
5.0
3.0

0.0
2.0

1.0 -5.0

0.0 -10.0
Jul-05
Jul-06

Jan-08

Jul-09
Jul-10
Jan-11
Jan-12

Jul-13
Jul-14
Jan-15
Jan-16
Jul-16
Jul-17
Jan-06
Jan-07
Jul-07
Jul-08
Jan-09
Jan-10

Jul-11
Jul-12
Jan-13
Jan-14

Jul-15

Jan-17
Jan-18
FY05
FY06

FY09

FY12

FY15
FY16
FY07
FY08

FY10
FY11

FY13
FY14

FY17
FY18

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 Macroeconomic environment
Gradual recovery in private sector credit and investment

Lending Rates and Private Sector Credit Investment (percent of GDP)

21.0
Private sector credit WA Lending rate (rhs)

800 16.0
18.0
700 14.0

600 12.0 15.0

500 10.0
12.0
billion Rs

400 8.0

percent
300 6.0 9.0

200 4.0
6.0
100 2.0

0 0.0 3.0

-100 -2.0
FY01
FY02
FY03
FY04
FY05
FY06

FY08

FY10

FY12
FY13
FY14
FY15
FY16
FY17
FY18
FY07

FY09

FY11

0.0
FY01
FY02
FY03
FY04
FY05
FY06
FY07
FY08

FY13
FY14
FY15
FY16
FY17
FY18
FY09
FY10
FY11
FY12
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 Macroeconomic environment
Balance of payment situation has remained a source of concern
Balance of Payments SBP's Foreign Exchange Reserves and Exchange Rate
Current account balance Capital & financial SBP's Forex Reserves
End Month Rates (rhs)
16.0
20 130

12.0 18
120

8.0 16
110
14
4.0
100

billion US$
12
0.0
billion $

Rs/US$
10 90
-4.0
8
80
-8.0
6
70
-12.0 4
60
-16.0 2

0 50
-20.0
Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

Jan-16

Jan-17

Jan-18
Jul-06

Jul-07

Jul-08

Jul-09

Jul-10

Jul-11

Jul-12

Jul-13

Jul-14

Jul-15

Jul-16

Jul-17
FY07

FY08

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

FY18
FY09

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 Macroeconomic environment
Uncertain fiscal position and volatile budgetary borrowing from SBP

Fiscal Deficit Borrowing from SBP

9.0
1400
8.0 1200

7.0 1000

6.0 800

flows in billion Rs
percent of GDP

600
5.0
400
4.0
200
3.0
0
2.0
-200
1.0 -400

0.0 -600
FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15

FY16

FY17

FY18#
FY18#

FY07

FY09
FY10

FY12

FY15
FY08

FY11

FY13
FY14

FY16
FY17
# Estimate

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 percent per annum

10
12
14
16

2
4
6
8
Jul-06
Jan-07
Jul-07

State Bank of Pakistan

Jan-08
Jul-08
Jan-09
Jul-09
Jan-10
Jul-10
Reverse repo rate

Jan-11
Policy (Target) Rate

Jul-11
Jan-12
Jul-12
Jan-13
Jul-13
Jan-14
Jul-14
Jan-15
Monetary policy stance

Jul-15
Repo rate

Jan-16
Jul-16
Jan-17
Jul-17
Jan-18
YoY CPI Inflation (rhs)

0.0
4.0
8.0
12.0
16.0
20.0
24.0
28.0

percent
32
 Thanks for the attention!

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