The current level of high inflation remains the primary concern for sustainable economic growth, said the State Bank of Pakistan in its monetary policy statement on Saturday. "Its persistence carries risks for macroeconomic stability and increase in uncertainty, discouraging savings and investment in the economy and, in particular restricts the development of productive capacity of the economy and thus contributes in increasing the aggregate demand supply gap," it said.
Persistence of high inflation is also eroding competitiveness of exports through a real appreciation of the domestic currency, and if the difference between domestic inflation and that of the trading partners is not brought down, the pressure on exchange rate to depreciate could increase. In turn, this could make imports more expensive, causing domestic inflation to rise further, the statement said.
Moreover, persistence of inflation at elevated levels strengthens expectations of it remaining high, making it all the more difficult to have desirable effects of anti-inflation policies. Under these circumstances, to bring inflation down, even larger adjustments in the interest rate and exchange rate would be required. As a result, the contraction in economic activities could be relatively higher, and may prolong, it added.
Therefore, SBP primarily focused on high and persistent inflation, which was being exacerbated by a structural fiscal deficit, frequently financed by government borrowings from SBP. The direct link between the pace of government borrowings from SBP and the expectations that individuals and businesses formulate about future inflation was also emphasised and in SBP''s view, these expectations were a major contributing factor in pushing core inflation up, which often gets less attention than supply side factors like fuel and food prices.
"Consequently, the aggregate demand and supply gap is still large enough to push inflation further and surging international food and commodity prices are also playing a role in intensifying expectations of rising domestic inflation," the SBP statement said.
SBP Governor Shahid Kardar also pointed out in its press conference that inflationary pressure was already high at the beginning of FY11, and remained at elevated levels during first half of FY11. In December 2010, year-on-year CPI inflation was 15.5 percent while its average for H1-FY11 stood at 14.6 percent, he said, and added that not only did the contributing factors of inflation continued to prevail in H1-FY11, the economy also experienced an additional shock in the form of unprecedented devastating floods.
The SBP Governor said that the revised projection of average CPI inflation for FY11 falls in the range of 15 to 16 percent, along with high probability of double digit inflation in FY12. "To bring inflation under better control, the critical measures would be fiscal consolidation and reduction in fiscal deficit and government borrowings from SBP," he said, adding that these measures would support SBP''s efforts to contain monetary expansion and thus ease aggregate demand pressures.
At the same time, due to an improvement in the external current account, the increase in Net Foreign Asset (NFA) contributed to maintaining year-on-year reserve money growth at 16.6 percent. Thus, while there is a favourable compositional change in reserve money, the growth of its Net Domestic Asset (NDA) component still needs to be curtailed to reduce inflation, he said.