Policy rate and inflation

By Dr Muhammad Abdul Kamal
March 25, 2023

In the 1970s, economists believed that inflation was primarily caused by ‘monetarism’, which is too much money chasing too few goods. They contended that the only way to control inflation was to keep the economy's money supply under control. Following this conventional or theoretical rationale, the State Bank of Pakistan (SBP) has been raising interest rates on a regular basis to limit the supply of money and control inflation expectations.


During the past year (March 2022–March 2023), the interest rate has increased from 11.37 per cent to 20 per cent, representing a substantial increase of 75.9 per cent. However, inflation during the same period soared from 12.70 per cent to 31.5 per cent. Like the previous year, Pakistan has left behind all regional countries by introducing a phenomenal increase in interest rates of 20 per cent. Despite a significant rise in interest rates, inflation remains stubbornly high, which raises the question of the effectiveness of a monetary policy in taming inflation.

First, raising the interest rate may not be an effective policy measure to control inflation since it is largely caused by global supply chain shocks. Covid-19 has disrupted the supply chain and the market equilibrium which is further exacerbated by recent sanctions on Russia leading to a further shortage of goods for consumers. Therefore, the inflation we are experiencing currently is cost-push inflation and monetary policy is not an appropriate way to cope with this kind of price surge.

Second, imported inflation is another factor fueling prices. Throughout the preceding decade or so, the government's heavy borrowing from commercial banks as well as international lending agencies have been placing pressure on our external sector leading to the depletion of foreign currency reserves, and further devaluation of the rupee. As a result, even though energy prices have remained relatively stable on the world market, the devalued rupee has made the same volume of POL now more expensive, triggering inflation.

Third, Pakistan’s informal economy which makes up 40 per cent of the country’s regulated economy raises concerns about the effectiveness of the policy rate. Pakistan's economy is very tenuously tied to the financial sector, with just 7.0 per cent of businesses accessing funds via conventional credit lending institutions. This is far lower than comparable countries like India (21 per cent), China (25 per cent), and Bangladesh (34 per cent).

The ineffectiveness of policy rates in achieving economic stability has serious repercussions for the government of Pakistan which is a significant borrower from commercial banks. The bulk of interest payments is made on a floating rate. The government's interest payments for the fiscal year 2022-23 were initially estimated to be Rs3950 billion. Nevertheless, interest rates have lately been drastically hiked, and payments at the current 20 per cent interest rate have risen to Rs5400 billion. The interest rate may increase further to anchor inflation expectations, which may exacerbate government expenditures via higher interest payments. As a corollary, additional taxes are projected to be levied in order to make budgetary adjustments, which would further exacerbate inflation. The country will stay locked in a vicious spiral until fundamental structural reforms are implemented.

The rescheduling of the Monetary Policy Committee (MPC) meeting to meet the IMF conditionality raises serious concerns about the sovereignty of the SBP and its ability to make independent decisions per the requirements of Pakistan’s economy. Additionally, in the MPC statement, the next policy meeting is scheduled to be held on April 4, and due to prevailing inflationary pressure a further hike in interest rate is predicted.

The current policy rate of 20 per cent, with the corresponding KIBOR rate ranging from 22 per cent to 23 per cent, poses a significant challenge to businessmen to generate at least a profit of 25 per cent. Several sectors that import raw materials for production will face increased costs as a consequence of tighter monetary policy and currency depreciation. The price effect will be passed on to the general public, and rising inflation is envisaged.

In the short term, the government must focus on regulating prices and improving governance. Surprisingly, food inflation which is a major contributor to the Consumer Price Index is higher in rural areas as compared to urban areas despite the former being source regions for food. Improved governance and market regulation can potentially bring down the volatility in goods markets and hence can offer some relief to desperate masses. Pakistan is expecting financial aid from friendly countries, which will relieve strain on the foreign account. Acquiring funding from friendly nations will increase food/necessary supply and hence reduce inflation.

The writer is an assistant professor at Abdul Wali Khan University, Mardan. He can be reached at: kamalawkum.edu.pk