It is quite clear that overall the monetary policy tool of raising policy rate to rein in inflation has not had any breakthrough for any significant period of time. In fact, the hikes in policy rate have had very little to dent inflation acceleration in any significant way in developing countries, including Pakistan.
Given a meaningful determination of inflation depends upon aggregate supply and governance related aspects, and not just mainly aggregate demand, it has remained quite regularly the case that interest rate raise into double digits in Pakistan, for instance, has had little meaningful impact in reducing inflation.
In fact, at higher policy rates the channel of cost-push inflation becomes quite significant for pushing the costs involved in the production and consumption processes, and feeds into building up further inflationary pressures, which most often than not outpace the retarding force of austerity policies to reduce inflation.
If the purpose of keeping policy rate high is also to boost foreign portfolio investment and cause a positive impact on reserve build-up, then it is too high a price to pay for attracting, otherwise, highly volatile ‘hot money’, whereby cost-push inflation increases, which in turn negatively impacts national production activity or economic growth; not to mention the adverse effects on real wages, and purchasing power of people squeezing more than needed decrease in aggregate demand, in turn, pushing towards stagflationary consequences.
Moreover, a higher interest rate is also given a lot of unwarranted weight by policymakers by assuming that people borrow credit to make consumption expenditures, including imports, in a significant way. In the case of developing countries, including Pakistan, in general, lack of financial deepening has kept this channel of consumption on less significant grounds.
Having said that, efforts to curtail imports through keeping high interest rate on borrowing in any case entails a lot of price for the economy in terms of its significant diminishing effects on economic activity, real wages, and unemployment, in addition to also feeding into pushing up cost-push inflation, and pushing up interest payments on domestic debt, which eats into the already narrow fiscal space.
Keeping high policy rate also negatively impacts exports, and its impact in terms of raising the cost of doing business also increases the likelihood of curtailing foreign direct inflows.
At the same time, while it is important to manage float, the current policy of keeping exchange rate well below the real effective exchange rate opened the door for immense speculative activity that kept the rate of US dollar against the Rupee much higher outside of the banking channels with a drop in remittances entering through banking channels, with negative consequences for foreign exchange reserves build-up.
Instead, imports could be curtailed through a well-defined and transparent import compression policy, having inbuilt import tariffs and administrative controls, with proper prioritization of imports in terms of restrictions, so that while less-important imports are curtailed, essential items are imported as per the needed level.
The above dynamics and impacts are of quite meaningful consequence in rather normal times in terms of global- and developing country-level economic activity, but since the pandemic – its recession-causing, and inequality- and poverty-enhancing impact, the fast unfolding of climate change crisis in recent years, the global aggregate supply shock, and the serious build-up of current account and debt distress for many countries, not to mention the urgent and deep need to make needed health-, climate, and welfare-related expenditures to reach a resilient and inclusive global economy that is better prepared to weather a world of poly-crises – over-utilizing policy rate has exacerbated the negative impacts, especially in terms of the high price to pay to have small economic gains.
Hence, instead of over-using policy rate, and overall austerity measures to control inflation remains quite futile options, and in fact remain rather damaging in terms of the heavy economic costs. It is, therefore, important for both government and the International Monetary Fund (IMF) that instead of over-doing on the aggregate demand side in terms of squeezing it, inflation needs to be controlled more actively by improving the aggregated supply situation, in addition to taking greater regulatory measures to improve the efficiency of markets.
Moreover, another important factor is reducing the impact of imported inflation, especially at times of global aggregate supply and when strong recessionary winds are once again building up– only after around two years since pandemic-caused recessionary happened overall globally during the first year of the pandemic – which requires greater financial support multilaterally, particularly in terms of adequate release of special drawing rights (SDRs), and provision of meaningful debt relief to developing countries, including Pakistan.
One important policy for both the government and the IMF to quickly consider, given the high level of inflation for a number of months now for Pakistan, is to also adopt policy at the micro-, disaggregated level at the sectoral level.
Hence the situation gives birth to questions such as which sectors are important for the overall economic activity, how they get affected by exogenous shocks – especially in current times of a world affected by multiple crises, including fast-unfolding existential climate change crisis, still on-going pandemic, and the war in Ukraine exacerbating the already existing supply chain crisis in the wake of the pandemic – like the oil prices rise the most, how prices are reached, how different price determination components, including taxes and competition, impact the overall prices of commodities and services being produced.
Thereafter, policy is formulated to improve the price determination process, and in controlling/managing prices through a policy of positive and negative incentive structures, so that both the rate of increase of prices for that particular commodity/service is optimal for the overall inflation and economic activity.
China during its formative years of its economic development, in the 1980s and onwards, adopted this kind of policy to control prices for not better inflation and growth consequences, but also for improving the composition of economic activity to make it more inclusive and sustainable; with positive consequences for inequality and poverty.
In this regard, a 2022 research paper ‘Inflation in times of overlapping emergencies: systematically significant prices from an input-output perspective’ co-authored by noted economist Isabella M. Weber, among others, highlighted the use of such disaggregated policy through the use of input-output tables strategy. Given weak market fundamentals in Pakistan, and with inflation at least equally a fiscal phenomenon ever during normal economic times, such an approach appears to hold significant potential for both reducing inflation, and meaningful play a part in avoiding over-use of monetary tightening policy.
The paper pointed the importance of viewing inflation in not just a macroeconomic phenomenon, but to dissect it, especially in the case of important sectors for overall level of economic activity in the country, and to analyze the price increases at the sectoral and micro levels.
The paper indicated in this regard: ‘We use simulations of price shocks in an input-output model to pursue an alternative approach to the view that inflation is exclusively macroeconomic in origin. In policy debates, most economists have until recently tended to see inflation as a purely macroeconomic phenomenon: Monetarists as the result of “too much money chasing too few goods” and New Keynesians as a matter of the relation between aggregate demand and capacity utilization.
The key variables to control inflation from both perspectives are thus macroeconomic: the quantity of money and government spending. … By identifying the specific sectors that matter most for general price stability, we contribute to the on-going expansion of the toolbox of stabilization policies. When faced with large sectoral shocks, it is not sufficient for monetary stabilization to rely on purely macroeconomic means designed to respond to demand-pull inflation.’
Instead, the paper advocates adding the ‘input-output setup, under an overall Leontief price model to the policy toolkit to control inflation. The paper highlights the benefits of this as follows: ‘We simulate how in an input-output setup a price shock in any specific industry cascades as a cost shock through the whole system, leading to changes in the general price level. This means that we not only take direct effects of a price change on the consumer price index into account, but also the myriad of indirect effects that follow cost changes in other sectors.’
Copyright Business Recorder, 2023
The writer holds a PhD in Economics from the University of Barcelona. He previously worked at the International Monetary Fund. He tweets @omerjaved7