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Monetary Policy is a subset of public policies and the ultimate objective of every public policy is to improve the welfare of citizens. Social and economic welfare is believed to increase with reduction in inflation and poverty; increase in growth and employment; and betterment of income distribution.

Common sense dictates that a central bank cannot achieve all these objectives. Literature on monetary economics and central banking indicates that it must focus on a couple of objectives, of which one is primary and other secondary. Low inflation, or price stability, is universally considered a primary objective as central bank’s monetary actions have relatively more lasting impacts on inflation than growth.

According to Michael Woodford, a leading monetary economist, there exists a fair amount of consensus in the academic literature that a desirable monetary policy should minimize the welfare loss arising from deviations from a target rate of inflation as well as from potentially achievable output. While this consensus suggests that output target should be set close to its achievable potential, it is deliberately silent on some specific level of inflation as a universal target. It recognizes the need for setting a relative higher target for inflation in developing countries compared to what is the norm in advanced countries.

There is also a consensus in academic literature that the inflation target should be set by an authority higher than the central bank. Once the target is specified, the central bank should, however, be empowered fully and independently to use all the instruments to minimize the loss function suggested by Woodford. Therefore, central banks should be given full “instrument independence”, but not the “goal independence”. Authorities higher than a central bank are always free to define price stability in a manner conducive for growth. This is to ensure a prudent balancing between the targets of inflation and growth. The higher authority in our case is the National Economic Council, which approves the economic planning process.

Existing SBP legislation suffers from various weaknesses. Its objectives are murky, and its governance is manifestly mired by the fact that its past four Governors were not able to complete their very short tenure of three years (the shortest tenure among the central banks of the world). There is a Monetary and Fiscal Policies Coordination Board, which at best hardly adds any value to either fiscal or the monetary policy. At its worst, it acted more like a fiscal dominance board. Functions of this board are extremely vague, notwithstanding the beauty and usefulness of the word “coordination”. An independent review of its experience will clearly show its redundancy. Ministry of Finance is the single largest borrower from SBP, but the Secretary Finance sits in its Board of Directors – a clear conflict of interest. SBP’s Monetary Policy Committee is empowered to set the interest rates and other monetary instruments, but not the exchange rate. This is a major weakness. Even in the much talked about recently proposed amendments to SBP Act, the Monetary Policy Committee (MPC) has not been empowered to change the exchange rate even in situations when it is going to create difficulties for the country’s balance of payments.

So far, it is good to know that the current exchange rate mechanism of “market-determined exchange rate” has kept it flexible, but without full independence, MPC will not be empowered to correct the course of exchange rate in future, if it deviates from the desired path consistent with sustainable growth. While the proposed amendments empower the SBP in its functions to undertake the exchange rate policy, it is likely to remain susceptible to political pressures in future keeping the foreign exchange artificially cheaper. In order to minimize this grave risk, MPC needs to be empowered appropriately.

In the prevailing media discussions, various imaginary pitfalls and dangers are being described ferociously about an independent State Bank! It is absurd to even think that our central bank can ever become so powerful to work against the national interest. I don’t want to repeat those imaginary or mis-perceived pitfalls here. I am, however, shocked and saddened by the quality of prevailing debates on SBP independence. As a result of the quality of these debates, a serious new challenge has emerged for the State Bank as the monetary policy effectiveness depends on how the central bank manages expectations of the public.

I can understand that it is almost impossible for the State Bank to engage with the media because the amendments have not yet been taken up for discussion by the Parliament. But the prevailing baseless fear-mongering is going to make it difficult for the SBP to manage expectations until the Parliament legislates its own version in its own wisdom.

Proposed amendments will strengthen the functioning of SBP, except for the major weakness about the MPC not being empowered to influence the exchange rate. I hope that Parliament will remove this weakness and pave the way for our country to break the future cycles of crises in the balance of payments and help steer the economy on a sustainable path of growth, without superficially created booms leading to almost certain busts. In my view, the exchange rate is a far more important instrument compared to the exchange rate in correcting various imbalances which are hurting our country’s economic well-being. Therefore, monetary policy independence should not be confused with “interest rate independence”.

(The writer is a former Deputy Governor, SBP)

Copyright Business Recorder, 2021


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