LIMITS OF MONETARY POLICY

BY DR ASHFAQUE H KHAN DEC 14 , 2010

 Inflation is on the rise in many countries in the Asian

region.  Rising food prices are found to be the major driver behind inflation in the region.  The rising food prices are causing a surge in overall inflation, particularly in low income countries where such prices account for a higher proportion of the inflation basket.  Rising food prices are of a major concern because they represent a higher proportion of spending for the poor than for the general population, especially in low income countries.

primarily weather-related international developments and the increasing incidence of financial speculation in commodity markets. Kazakhstan. including in Pakistan?  Increase in food price is largely driven by external factors. Ukraine and Russia. especially wheat production of major exporters such as Canada. .  Key crop harvests have been affected by adverse weather events. Why are food prices on the rise in the region.  Wheat prices were further affected by the announcement of an export ban by Russia in August 2010.

 Massive liquidity injection resulting from easy monetary policy pursued by developed economies in the aftermath of the 2008 crisis is fuelling speculation in food markets and driving up food prices. .  In the case of Pakistan.  Investment in commodity markets has crossed $300 billion in July 2010 and is causing a speculative bubble in these markets. Apart from weather-related developments the entry of financial investors in international commodity markets is creating volatility in food prices. the unprecedented floods that damaged crops and disrupted the supply situation as well as the weakening of state authority are contributing to the surge in food prices.

Inflation in Pakistan  The above analysis suggests that inflation in Pakistan is supply-side  In the absence of clear signs of an excess demand in Pakistan tightening of monetary policy would thus be ineffective to deal with the root cause of inflation. .

Monetary Policy?  By tightening monetary policy. improve the writ of the state. can we reduce food prices. force the government not to pass on the rise of POL prices to domestic consumers. and stop the government from borrowing from the Central Bank to finance budget deficit? . prevent government to raise power tariff.

 Especially. .  In such an environment growth would remain low.. a higher discount rate is raising the entire term structure of interest rates and hurting private sector investment.  Dampening the general level of demand in the economy through further tightening of monetary policy is detrimental to growth.Effects. joblessness and poverty would continue to rise. job creation and poverty alleviation.

Therefore the approach to monetary policy continues. the sources of inflation must be identified. Simply tightening of monetary policy without finding the root cause of inflation is bad economics. believes that “inflation is always and everywhere a monetary phenomenon”.Author’s Views  The author has been advocating the pursuance of tight monetary      policy until the last monetary policy announcement. The Monetary Policy Department on the other hand. Before taking any decision regarding monetary policy. The Research Department believes that inflation in Pakistan is driven by food inflation for which monetary policy is not the right instrument. The last increase in discount rate was unjustified and the SBP. at best. could have maintained a status quo. .

 SBP should reconsider its monetary policy stance.  Last three years of low growth have thrown millions below the poverty line and millions have joined the pool of the unemployed.Suggestion  Prudent monetary policy requires finding the root cause of inflation in the absence of demand pressure. there is a need to review the monetary policy stance. With external balance of payments not so fragile. .

POLICY RATE AMID FISCAL SLIPPAGES BY: NASIR JAMAL OCT 4. 2010 .

 THE State Bank of Pakistan hiked borrowing cost last week for a second time in two months  The decision is an attempt to pre-empt inflationary expectations in the economy .

needs to bring its fiscal policy in line with monetary policy objectives.  the SBP says. It also sends a signal to government to implement tax reforms and resolve circular debt in the energy sector to contain fiscal deficit and its inflationary borrowings from the central bank. .

23 per cent in August .50 per cent may not immediately alleviate fiscal pressures or curb prices  inflation spiked to 13. The half a percentage point increase in the bank`s key policy rate to 13.

. “The central bank`s hawkish stance on interest rates is unlikely to control inflation  A SBP official concedes that the rate hike will not have immediate impact.

3 per cent of gross domestic product (GDP) against the target of 4. .9 per cent last year. The economy had been facing strong headwinds even before floods displaced  Inflation was higher than the budgetary target and the fiscal deficit stood at 6.

5 per cent. The floods forced government to cut its GDP growth forecast for the current financial year to 2.5 and last year`4.5 from the original target of 4. .5 from its pre-flood forecast of 12.1 per cent  The SBP has revised upward its estimate of inflation to 14.

for example.  The benchmark 6-month T-bill.  Scheduled banks were reluctant to invest money in T-bills of tenures more than 3-month in anticipation of further increase of another 50bps in the rates during the November review. had increased 30bps. . The market was anticipating monetary tightening on inflation concerns and was pricing in up to 50bps hike in lending rates.

 Financial analysts agree that the bank did not have much of a choice here because of the widespread concerns about fiscal imbalances and inflationary pressures. . they insist that it should have waited for the completion of the World Bank/ Asian Development Bank assessment on the flood losses to the economy before raising the rates.

 The fiscal pressures are likely to grow during the current financial year and force the government to borrow more from the SBP and the scheduled banks if its spending rises on account of post-flood reconstruction and rehabilitation and if it does not take action to raise more revenue or the pledged foreign assistance does not arrive. .

saying the central bank had ignored significant risks to economic growth by continuing its hawkish stance on lending rates.  “It will not curb inflation. a leader of the Pakistan Industrial and Traders Associations Front effectiveness of government efforts to contain the fiscal deficit and its inflationary borrowings from the SBP and the banking system. according to the monetary policy statement. It will only increase cost of doing business and discourage fresh investments. the business community has expressed its deep displeasure over the decision to raise the credit costs.” contends Irfan Qaiser.  The next quarter will be crucial in forming an assessment of the . As expected.

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