Steady, tight money

The State Bank of Pakistan’s decision to maintain its policy rate steady at 22 per cent is quite in line with market expectations and, coming at a time when a newly elected government has just assumed power, further validation of the central bank’s policy independence. The Monetary Policy Committee (MPC) has correctly argued that although the central bank’s tight money approach has started to pay off in terms of more subdued year-on-year headline inflation in January, this is no time to let up on the high policy rate for a variety of reasons. In other words, while the downsides of a contractionary monetary policy are not lost on anyone, throttling inflation and bringing down inflation expectations has to take priority over growth for now. High inflation stunts growth in its own way, and it confounds businesses and households alike by making it difficult to estimate what their nominal costs in the coming month or quarter will be. This can throw a pall on consumer spending and business investment, exerting a drag on economic growth. Most importantly, for an economy like Pakistan’s with high external debt, inflation can boost debt servicing costs by eroding the value of domestic currency.

The central bank’s accent with inflation expectations is also understandable as they play a huge role in determining inflation over and above the market fundamentals, becoming a self-fulfilling prophecy. That the announcement comes in Ramazan provides a useful window for an exposition of this phenomenon. Consumers and traders alike associate this time of the year with high food inflation, owing basically to the higher-than-normal demand. In practice, however, prices shoot up even for products whose demand remains steady. Unfortunately, those with the least monetary resiliency are always hit the hardest by these trends: the salaried class and pensioners whose incomes do not rise with price hikes.

Then there is the vicious cycle of the wage-price spiral: When workers’ inflation expectations are unanchored, they feel justified to demand higher wages to maintain their purchasing power. However, any businesses agreeing to such increases will inevitably raise their prices to absorb the increased labour costs. High inflation expectations thus lead to actual high inflation, in turn further reinforcing inflation expectations. It is therefore essential for the central bank to beat inflation expectations until they are anchored around a reasonable target. We are clearly not there yet, as evidenced by inflation beating the central bank’s earlier projections despite moderating.

The biggest dividend of the steady monetary tightening by the central bank up until now has been the relative stability achieved by the rupee. Combined with the fragile farm-led recovery, fiscal consolidation and improved revenue collection achieved under the caretaker government, and exogenous factors like the easing of global commodity prices, this has helped slightly improve Pakistan’s primary and current account balances. The expat workers’ remittances have also been improving, primarily backed by a steady migration of remittances to formal channels. Still, the overall deficit has widened because of debt service outflows necessitated by the high level of the country’s indebtedness. In particular, the high foreign debt burden continues to be the Achilles’ heel of Pakistan’s economy, locking the country in an embrace with foreign lenders led by the IMF. An IMF team in town to negotiate the release of a $1.1 billion tranche of monetary support is, therefore, the final argument in favour of the continuation of the tight monetary policy.