Monetary policy and inflation

Addressing members of the business community at a function organised by the Federation of Pakistan Chambers of Commerce and Industry (FPCCI) recently, the State Bank governor, Shahid H Kardar was quite lucid in elucidating the role and limitations of monetary policy in containing inflationary pressures in the economy.
While recognising the importance of supply side impacting the level of availabilities in the economy and the output gap, he opted to be much more emphatic about the effect of increasing aggregate demand on the rate of change of prices, that is, inflation. In cumulative terms, Pakistan's economy had experienced an inflation of 66 percent between October, 2010 and June, 2007 or almost twice the level of inflation of 36 percent seen during June, 2003 and June, 2007.
Kardar dilated upon the factors which had cast a negative impact on the rise in prices. Subsidised commodity prices including that of petroleum products, electricity and gas, had resulted in enormous government borrowings from the central bank. Borrowings of PSEs, which partially explain transfer of subsidies from the government's budgetary expenditures directly to the power sector entities, grew by 305 percent during October, 2010 and June, 2007 as compared to only 17 percent in the preceding four years. With the steady increase in overall fiscal deficit, the stock of government borrowings from the SBP was now in excess of Rs 1500 billion as compared to only Rs 53 billion at the end of June, 2003.
Another downside of the heavy pressure of government borrowings was the deterioration in currency-to-deposit ratio by the banking system. "The continuation of these trends is fuelling expectations of inflation and, resultantly, in interest rates remaining high. Thus, if anything, the criticism on the SBP's current monetary policy stance would be that it has not been tight enough". Obviously, the central bank has to strike a proper balance between varied considerations.
Kardar also maintained that monetary policy had played its part in correcting the macroeconomic imbalances, but other government policies have not been that supportive. Had the State Bank not followed a "so-called" tight monetary policy stance, the rate of inflation would have been much higher. Future strategy to control inflation must include co-ordinated and timely response to changing macroeconomic conditions along with a concerted effort to raise the productive capacity of the economy. "Delays in implementing such a strategy would only make the policy trade-offs much more difficult resulting in continuing uncertainty regarding desirable economic outcomes".
We feel that the Governor, State Bank has done a good job in analysing the phenomenon of inflation in a comprehensive manner, with particular reference to the reasons leading to its present high rate and the steps that could be taken to contain inflationary expectations. Such a discourse with the business community should serve to raise the awareness level and, to a certain degree, may soften its criticism towards the consistent tightening of monetary policy followed by the SBP to contain aggregate demand in the economy.
Kardar has acknowledged that private sector gets hurt in the process but inaction on the part of the State Bank or other alternatives to the present monetary policy strategy are much more risky and unpalatable. Understandably, as stated by him, a flawed fiscal policy is the major factor, necessitating greater recourse to bank borrowings to finance the budget deficit, crowding out the private sector from the credit market and contributing excessively to the recent sharp increases in prices.
Larger credit requirements for PSEs and commodity operations have further compounded the problem. In whatever way we approach the problem, the truth cannot be ignored that mobilisation of higher level of resources together with elimination of subsidies and privatisation or at least major restructuring of the loss-making PSEs is a national imperative that would also soften the price pressures and make the task of the State Bank to formulate monetary policy easier. A country unable to raise enough revenues to meet its expenditures cannot secure its economic future and would continue to face severe problems. The main elements of critical reform efforts needed to pull the country out from this quagmire are well known but factors like official prevarication, partisan posturing, and opposition grandstanding coupled with mass resistance from those likely to be affected or documented are big hurdles to improve public finances of the country.
Kardar has highlighted all in his address and justified the policy response of the State Bank but has refrained from advising the government on precise policy measures for obvious reasons. The message that increasing government reliance on the banking system is jeopardising monetary stability has again been conveyed by the State Bank in its Financial Stability Review 2009-10 released on 14th December, 2010. However, whether the government will be able to take the necessary tough decisions in a difficult political environment is anybody's guess.
While nobody would disagree with the State Bank's position of improving public finances of the country and a co-ordinated approach between fiscal and monetary policy to tame inflation, one would, however, argue that the State Bank itself had abdicated its responsibility to a large extent to influence the government against excessive bank borrowings and fall in line.
Such a course of action, if adopted, might have indirectly contributed to price stability. In its present form, the State Bank Act authorises its Central Board to "determine and enforce, in addition to overall expansion of liquidity, the limit of credit to be extended by the Bank to the Federal government, provincial governments and other agencies of the Federal and provincial governments for all purposes..." In the presence of such a powerful tool in its hands, its complaint of excessive bank borrowings by the government does not seem very convincing. Moreover, it has not so far taken adequate measures to narrow the interest spreads that would increase the return on deposits, reduce the currency to deposit ratio and mobilise higher level of savings in the economy. While the government's mismanagement of public finances may be the main cause, the State Bank also needs to play its due role in maintaining price stability in the country by being more assertive.