A Milton Friedman approach?

The State Bank has again opted to keep the policy rate unchanged at 5.75 percent for the next two months. In its Monetary Policy Statement (MPS) released on 25th March, 2017, it seems to have argued that there are no compelling reasons to act otherwise as all the relevant indicators continue to radiate positive signs. Inflationary expectations are well anchored during the current fiscal year due to near-absence of any major supply side pressures. There were, however, signs of pick up in domestic demand due to rising real incomes in a low interest rate environment. "Hence, barring any major cost shocks, domestic demand will define the underlying trend of headline inflation in FY18." GDP growth was expected to improve further in FY17 as real economic activity was gathering pace at the back of better agricultural output, increase in LSM sector and a healthy uptick in private sector credit. A prudent monetary policy stance and low market interest rate have incentivised private sector to borrow from commercial banks to finance their businesses and investment activities. Private sector credit increased by Rs 349 billion during July-February, 2017 as compared to Rs 267 billion in the same period of last year. Both fixed investment and consumer financing led to the rise in private sector credit while improved interbank liquidity conditions spurred the growth in this credit.
The MPS has, however, recognised that "the expansion in economic activity has translated into a significant increase in imports, which along with the lack of any sustained improvement in exports and a small decline in remittances has pushed the current account deficit to dollar 5.5 billion during July-February, 2017." Financial inflows were not sufficient to finance this deficit. However, as a result of positive impact of the recent policy measures to augment exports and check non-essential imports, the current account deficit may be contained in the coming months. Continuation of the financial inflows, the CPEC-related imports and fluctuations in global oil prices will determine the overall position of the foreign sector in FY18.
The arguments advanced by the SBP to keep the policy rate unchanged at 5.75 percent per annum would appear to be quite convincing. As is normally the case, the central banks usually take into account the rate of inflation, external sector position and the developments in the real sector while formulating their monetary policies and the SBP has only followed the traditional pattern which is largely characterised by a Milton Friedman approach to monetary matters. The rate of inflation is still subdued and is likely to be around 5 percent for FY17 compared with the target of 6 percent. This seems due to a comfortable supply position though the demand pressures are likely to accentuate due to rising real incomes and lower interest rates. The State Bank also does not seem to be worried about the negative developments in the external sector. It believes that the recently policy measures to expand exports and contain imports would contain the current account deficit while financial inflows, the CPEC-related imports and fluctuations in international prices would determine the outcome in FY18. GDP growth rate was likely to be helped by a host of factors, including improvement in private sector credit, upbeat economic sentiments, better energy supplies and the CPEC-related investments.
Although the State Bank has made a reasonably good case to justify an unchanged monetary stance, yet a positive spin seems to have been given to the relevant indicators to arrive at a pre-conceived decision. For instance, the latest reduction in the policy rate was made in May 2016 and since then this rate continues to be unchanged at 5.75 percent though the fundamental factors affecting the monetary policy have deteriorated to a great extent. Last year, inflation rate was recorded at about 2.8 percent which is going to be much higher this year. In order to safeguard the flow of credit to the private sector, the government is resorting to the SBP for budgetary financing which is quite inflationary. The situation on the external sector is much worse. The current account deficit registered in the first seven months of the current fiscal year was more than double as compared to the corresponding period of last year and nobody seems to be much worried about this highly negative development. The assumption of the SBP that recent policy measures to expand exports and check non-essential imports would be effective in containing the current account deficit of the country does not seem to be realistic. Package offered by the government to exporters and the imposition of 100 margin requirements on imports of non-essential items would hardly make any difference to the overall balance of payments position of the country. The government, despite an alarming deterioration in the trade and current account deficits, is still insistent to maintain the existing exchange rate of the rupee, which is rendering exports uncompetitive in the international market and encouraging the flow of imports to the country. While the MPS is quite optimistic about growth prospects, it will not be possible to achieve and sustain a respectable growth rate until and unless saving rate of the economy could be raised to around 20 percent or so. In a situation where deposit rates offered by commercial banks are generally lower than the inflation rate, savers would not be tempted to save more with the result that saving rate of the economy would continue to be depressed. In our view, the SBP should have compared the present situation with the one obtaining in May, 2016 when the policy rate was brought down to 5.75 percent. Such a comparison would have persuaded the SBP to increase the policy rate somewhat. The rigidity shown by the State Bank could please the government as well as the business community but would not be helpful in containing inflationary pressures, reducing C/A deficit and increasing saving rate of the economy. Hopefully, the State Bank would analyse these aspects more carefully next time with a view to reaching the right conclusions.