Inflation, RGST and the revised SBP Act 2010: Explaining simple economics

Two important sources of inflation in Pakistan have come to the forefront: government's excessive reliance on the SBP and inflationary expectations. With latter leading to persistence in inflation at high levels despite a fairly stable rupee-dollar parity over the last two years. Inflationary expectations refer to the views of different economic agents (consumers & businesses) on future prices.
This article further discusses these two sources of inflation and the solution that would address galloping inflation. The State Bank believes that implementation of the further revised State Bank-Act (redirecting focus on lowering inflation), the proposed RGST-bill and a reduction in fiscal deficit can result in a permanently lower inflationary scenario. This was also highlighted in the Monetary Policy Statement November 2010 as follows:
"...To increase its capacity to raise revenues and contain inflationary borrowings from SBP within an explicit and clearly defined limit, the government has shown its intention to: i)- widen the tax net through introduction of the Reformed General Sales Tax (RGST) along with other tax measures; ii)- effectively contain the power sector subsidies; and, iii)- amend the SBP Act, including explicit limits on government borrowings from SBP, which is now in the final stage of legislation. Together, these could potentially address the problem in the medium term of stubbornly high inflation expectations, reduce the cost of borrowing, and hence pave the way for long term economic growth. However, it may take some time before the benefits of such important measures, after their implementation, begin to have their impact."
This passage from the Monetary Policy Statement is referring to economists' belief that in an economy with persistently high inflation, economic agents (consumers and businesses) must alter their views about inflation in order to actually bring inflation down in the future. A credible shift in government policy can cause people to revise their expectations about future inflation. Such a shift, known as a structural change, is especially relevant when the government itself is an important source of generating negative views about the inflationary scenario.
In some Western and emerging economies, such a structural change has meant granting independence to their central banks with the sole mandate to bring price stability. Research shows that such structural change can bring confidence about lower future inflation and reduce current inflation levels. This argument is backed by strong empirical evidence from 20 countries that embraced central bank independence at various points in history. In Fig. 1, we plot the average of trend inflation five-years-before and -after the central bank independence of these countries.
In Fig. 1, moving from a situation before independence (the left-hand-side) to after independence (the right-hand-side), there is a clear downward shift in average inflation trend of all countries (the dashed line). Furthermore, in Fig. 1 we can see that emerging markets (crosses) such as Mexico, Colombia and Chile have been able to permanently bring inflation down. Countries such as South Africa and Israel with similar macroeconomic features as Pakistan have also been able to tame inflation after independence of their respective central banks. Such compelling evidence leads us to believe that central bank independence can be a useful tool in harnessing inflation in Pakistan.
The reason the Pakistani government should give its central bank some independence rather than committing to a policy of low inflation by simply 'saying that it would' is because of the trust deficit between ordinary people and the political class as a whole. For example, the government promises to keep inflation low and the economic agents fix their prices and wages on the basis of this commitment. But, once agents have fixed their prices and wages, government goes back on its promise and resort to printing money, this results in higher inflation making everyone worse-off. A simple way to resolve the commitment issue for the government of the time is to give the authority to print money to an independent central bank alone with the main objective of maintaining low prices.
This is precisely what policy-makers in the present government and the State Bank of Pakistan (SBP) are hoping to achieve through the revised SBP Act 2010. When enacted, this bill will tie the hands of the government by limiting its ability to finance spending by printing money, thereby fulfilling its promise of keeping inflation low.
Often it is argued that low inflation is synonymous with low economic growth. The empirical evidence from the 20 countries with independent central banks in our analysis suggests otherwise. In Fig. 2, we present the 5-year average of trend growth in real output per person before (the right-hand-side) and after (the left-hand-side) central bank independence. Moving from left to right in Fig. 2, it is clear that on average (the dashed line) there are no significant differences in the 5-year average of trend growth rates. Figs. 1 & 2 together imply that most countries adopting central bank independence have been able to lower inflation without significant loss in the growth of real output per person.
In sum, international evidence suggests that central bank independence can lead to a lower inflationary scenario without much loss in average income per person growth trends. However, the question remains whether such a strategy would work for Pakistan, with our historically high fiscal deficit and acute funding needs, especially in the light of our security needs and higher spending requirement on the account of the recent floods. It is commendable that the government is attempting to commit to low inflation, but it would be equally important for the government to find alternative sources of non-inflationary financing to plug its massive financing needs.
Therefore, to bring credibility about its seriousness to curb inflation, the government has demonstrated its intent to raise revenues from alternate sources like the RGST. Thereby sending a clear message about how it aims to recoup part of its previous inflationary borrowings from the SBP from non-inflationary sources through taxation, while giving the State Bank some independence.
This package of amended SBP Act 2010 and RGST 2010 is a unique blend but politically challenging. In economic theory, it is sufficiently strong to curb the inflationary expectations emanating from the financing behaviour of the government. Of course, this structural change will resolve only part of the inflation problem in Pakistan since another important source of inflation is food items; a topic we reserve for a future article.
Courage, willingness and a natural vision from the government, the entire political leadership, the State Bank and civil society as a whole are required to ensure the urgent legislation of these laws and to halt inflation, public enemy number one.
(Dr Ali Choudary is Director State Bank of Pakistan; Farooque Pasha is Sr. Joint Director SBP. They were assisted by Hasan Abbas Research Assistant.)