Every time monetary policy is issued by SBP, a debate on its consequences and effectiveness begins, particularly when a tight monetary policy stance is adopted by increasing the policy rate. Most of these apprehensions reflect concern for growth, which is valid but usually entail short-term growth prospects.
Economies do witness short term fluctuations in growth; however, what should be more of a concern is long term growth. Also, in such arguments for growth, often what is missing is the due consideration for bringing down inflation. Low inflation is the key for ensuring long term growth. Over the last several years, SBP has been forcefully advocating for a sustained decline in inflation, arguing about its causes and consequences in its monetary policy statements.
Some readers find SBP stance and arguments to be unsympathetic for growth and consider them 'hawkish', whereas SBP argues that giving more consideration to price stability is, in fact, a pro growth policy. To make monetary policy more effective, it is important that all the stakeholders get a clear message on policy stance out of SBP communications. In this context, it seems appropriate to answer some basic, but very important, questions about monetary policy. Some of these are: why price stability is important, what causes inflation and what monetary policy can do to maintain price stability and promote sustainable growth.
Why price stability?
Before asking why price stability it would be pertinent to understand what is price stability. Price stability does not mean unchanged prices or zero inflation. It simply means that prices do change but do not change at a pace which creates uncertainties for people. Which level of inflation should be considered as stable varies across countries. For developed countries, annual inflation even beyond 2 to 3 percent is considered as high whereas for developing economies, it is generally accepted that a relatively higher level of inflation would remain present during the process of economic development.
For Pakistan, annual inflation in the range of 4 to 6 percent is generally considered as stable.
In economics jargon, the return on savings compensated for the price increase is called the real rate of return or simply the real interest rate. To encourage savings in the economy and therefore to promote investment, the real return on savings should be positive. If the real return is negative, then there is more incentive to borrow.
The real rate of return on savings may fluctuate if prices are not stable. This suggests that price stability is a fundamental requirement for promoting growth as it determines the incentives to save. Therefore, when a central bank is given the objective of ensuring price stability, it does not contradict the objective of promoting growth. Monetary policy tries to maintain incentive to save by attempting to keep the real interest rates in the positive zone.
Another argument for price stability comes from price expectations of people. It is now an established fact that prices are also driven by people's expectations; prices start rising if all are expecting them to rise, even if there is no other reason for them to rise. If people expect that prices will continue to rise at a faster pace, this compels them to spend early since otherwise their expenditure in future will be higher and they might not enjoy the full benefits of their money. This expectation brings the inflationary pressure forward and fuels current inflation. Sharper changes in prices today lead to expectations of higher prices tomorrow and are incorporated by individuals and businesses in their future price quotations. Price stability, therefore, must be considered as complementing growth instead as a rival to growth.
What causes inflation?
Inflation is caused by the excess of demand over availability of goods and services. This excess could be due to higher demand for goods, for which there could be several reasons, such as increase in purchasing capacity due to income, borrowings, change in relative prices etc.
Many in Pakistan question that why Pakistan can't follow policies being pursued by the US and other developed Western economies. The answer is quite simple, the US is facing recession as well as deflation whereas Pakistan, though facing deceleration in growth, has a high level of inflation. Moreover, not only does the US economy have a high tax-to-GDP ratio, giving it room to allow tax cuts, it is relatively easier for them to finance their deficit with borrowings. As opposed to this, Pakistan has always been struggling to meet even its current expenditures with its revenues and has been financing its deficit by creating fresh money, since it has not even been able to borrow enough from other resources.
Money creation due to government borrowing from central bank is a source of inflation and nowhere is considered to be a prudent source of financing budget deficits. The maximum impact of such borrowings is when the money is used for meeting current expenditures only. If it is used for development purposes, then there may be some offsetting impact on inflation as capacity to produce in the economy increases with development work.
The next possible reason for excess demand, and, therefore, increase in prices, could be a fall in supply. This could be due to temporary shock such as floods, earthquakes, strikes, or any other reason, disrupting the process of production. There is a possibility that that supply could not be matched with demand since it has reached its peak capacity. While the temporary shocks die out with the passage of time or could be handled through short term measures, capacity development on a permanent basis requires well thought out consistent efforts.
Most of the times, we observe that both demand and supply increase; however, at times we face increase in the former at a higher pace than the later. This happens when there is idle capacity available for production. Once the production reaches the maximum potential available, supply cease to increase, whereas demand continues to grow.
What monetary policy can do?
From the earlier discussion, it should now be obvious that inflation can be controlled by reducing excess demand, either by reducing demand or increasing supply. Since increasing supply on a permanent basis involves long term policy as well as infrastructural changes, it leaves policy managers with the option of demand management only. Demand can be reduced by increasing the incentive to save or increasing the cost of borrowing. It can also be reduced by reducing income through lowering expenditures or levying higher taxes by the government. But this falls in the realm of fiscal policy.
Interest rates in the market are increased by lowering the availability of money in the money market when the central bank wishes to bring inflation down. High interest rates discourage consumption and investment and, therefore, reduce economic activity and demand in the economy.
Another important channel for monetary policy to ensure price stability is through affecting price expectations. A candid assessment of the latest economic developments, convincing projections of the future path of major macroeconomic indicators and a proactive policy helps in keeping inflation expectations at manageable levels. SBP's communication of its monetary policy stance with detailed explanations plays a very important role in this regard. SBP has been consciously making efforts in this regard.
(The writer is a Senior Economist at the Monetary Policy Department of State Bank of Pakistan) (abid.qamar@sbp.org.pk)