PBC urges use of core inflation for monetary policy response

KARACHI: The Pakistan Business Council (PBC) has suggested that the central bank should focus on targeting core inflation instead of headline inflation for its monetary policy response.

The PBC report, prepared by noted economist and CEO of Macro Economic Insights Sakib Sherani, says that Pakistan has experienced an “inflation shock” over the past two years due to exogenous price shocks in food commodities and energy. This has raised questions about the most “efficient” monetary policy response under such conditions.

“Since the recent inflationary episode in Pakistan was triggered primarily by exogenous price and supply shocks in the food and energy markets, it can be argued that the central bank should target core inflation rather than headline inflation, which includes volatile components such as food and energy whose prices are exogenous to the policy framework,” according to the report.

This approach could help create fiscal space for the government and reduce its dependence on high-cost domestic borrowings.“Doing so would generate critical fiscal space for the government, at a time when public finances are in a Ponzi game, and reduce the reliance on high-cost domestic debt under conditions of a large public debt overhang,” the report adds.

“This would also reduce the impact on output and employment via the sacrifice ratio,” it notes. “In sum, targeting the core inflation rate would have significant positive economic, fiscal as well as welfare consequences.”

Pakistan has experienced a high-inflation episode since July 2021. After initial inertia, the central bank responded with the aggressive tightening of monetary policy that has seen the policy rate increased to, and maintained at, 22 per cent for almost one year, according to the report.

Per the report: While headline inflation exceeded the policy rate by a wide margin for a period of time, leading to negative real interest rates despite the inflationary environment, core inflation as measured by non-food, non-energy price changes was significantly lower.

The study argues that there are merits and demerits of using core and headline inflation for monetary policy response. However, with a certain degree of flexibility and adaptability, depending on the specific circumstances and emergent causes of inflation, basing the central bank’smonetary response on core inflation may be more appropriate in Pakistan’s current high inflation episode.

The policy of maintaining a higher-than-needed policy rate for a protracted period has had substantial ramifications for public and private finances and GDP growth. The impact on private-sector borrowing in Pakistan is limited to the formal sector, and a high policy rate also affects tax revenues.

By using core inflation, the government could have saved interest expense by an estimated Rs829 billion in FY24 alone, or by over 11 per cent. This would have translated into a saving of approximately 0.8 per cent of the GDP, according to the report.

Another way to look at the potential budgetary saving is that it amounts to more than the entire allocation for federal pensions -- or running of the civil government -- and is roughly twice the allocation for the government’s flagship social safety net programme, the Benazir Income Support Programme (BISP).

Pakistan suffered an estimated output loss of Rs2,114 billion over three years through using headline inflation instead of core inflation for monetary policy rate setting. This was over and above the fiscal costs.