The SBP and price stability

Given its strongly recommended independence, the State Bank must deliver with its monetary policy. It must be held accountable if it does not

The SBP and price stability

Pakistan is in the headlines for high inflation. The Economist has ranked the country fourth highest inflation economy in the world out of 43 high-inflation economies. Headline inflation increased to 9.2 percent in October from 9 percent in September.

Worryingly, the country is expected to experience higher inflation throughout 2022. Higher and volatile inflation has economic as well as social welfare implications. It erodes the purchasing power of the people. It does more so for the poor who have lower income and spend almost half of it to buy food. In countries like Pakistan, where wage growth is low, high inflation can push many below the poverty line.

Despite the fact that inflation in India stood at 4.3 percent in September, the highest government offices in Pakistan continue to claim that it has done the best in the world to control inflation; that the petrol prices in the country are lower than India, Bangladesh and even the US.

These and similar statements signal a poor approach and lack of commitment to control inflation. On one hand, the common man feels humiliated and befooled; on the other, the profit makers take it as a signal for further price hikes. So, expect higher prices in the coming months.

It is true that many factors, such as international commodity prices, are beyond government control and that inflation is a global phenomena but Pakistan is clearly having a much higher level of inflation. Prices of commodities are rising with every passing day. According to a news report, the government has decided to not publish weekly sensitive price index of inflation. It has certain reasons.

Historically, price stability is an unfinished agenda in Pakistan. The State Bank of Pakistan (SBP) was delivering on the ever-changing inflation targets set by the government. According to the SBP’s Monetary Policy Framework, in order to maintain monetary stability, it is mandated to control “inflation close to sannual and medium-term targets set by the government.” This has proven a daunting task. With such an approach, monetary policy delivers on inflation targets but with eroded purchasing power.

The government-stipulated inflation targets change frequently and erratically, often so by wide margins making it challenging to anchor inflation expectations. A working from SBP shows that the target of inflation moved to 12 percent in 2012 from 5 percent in 2004. Even if the SBP delivered 100 percent on it, it will have eroded the purchasing power of the people.

Arguably, monetary policy in Pakistan was not shaped in terms of price stability and the purchasing power of the people. The race to meeting inflation targets led to volatile and unpredictable movements in the interest rates. Sudden shifts in monetary policy directions, from tight monetary control to an easy one and vice versa, flooded the market with uncertainty. Most importantly, the expectation formation of people was distorted. Higher average levels of inflation became a norm.

Without any doubt, monetary policy of the country should deliver price stability. The SBP must do it. All the excuses, whatsoever, need to go. All necessary arrangements must be made. The SBP, through its SBP Act 2021, is pushing for a number of fundamental structural changes.

The authorities must understand that central banking, particularly monetary policy, have significant distributional effects and cannot be undertaken in isolation from its socio-economic consequences.

The proposals include establishing an autonomous and independent central banking authority in the country while also redefining monetary policy objectives. These changes will generate significant consequences for social welfare, poverty and inequality in the country in addition to effects on macroeconomy.

Sustainable Development Policy Institute’s (SDPI’s) ongoing work on social footprint of monetary policy recommends a number of key actions and strategic policy directions, to help the SBP keep in line with modern practices in central banking and progress on the agenda of social footprint of monetary policy.

Primarily, the SBP must deliver on price stability. Price stability is critical for social welfare — particularly for low-income households. The inflation target must be defined with a focus on the welfare of the public at large, instead of random so-called growth enhancing inflation targets. It must improve real wage in the short run and productivity growth in the medium to long term.

The SBP must adopt an inflation-targeting regime in order to contain inflation at a given level, thereby maintaining price stability and preventing purchasing power from being eroded. However, given the socioeconomic structure of Pakistan, low and volatile economic growth, a high degree of informality, high inequalities of income, consumption, wealth and employment, and fiscal policy importance, an integrated inflation targeting (IIT) regime should be employed, instead of a standard model of inflation targeting (IT). Only an IIT caters to the characteristics of developing countries.

Delivering on price stability will, however, require a clear definition of price stability. SBP Amendment Act 2021 does not provide that. In this regard, secondary legislation must be done to identify what price stability exactly means. It should be a clear definition in black and white. Most importantly, the level of inflation to be targeted will be critical. 3 percent may be worth considering. The SBP may start with targetting around 5 percent inflation and move towards targeting an average inflation of 3 percent with deviations of -1 and +1.

This range can substantially reduce the income and consumption inequality imposed by higher inflation. At least, the inequality will not worsen further. This will help reduce poverty through creation of more job opportunities, increased income and purchasing power on account of higher economic growth and lower inflation. It can also minimise adverse effects of monetary policy that arise from a very volatile policy rate. Why will a central bank raise the interest rate when prices are stable? A high inflation target, such as 8 percent or 9 percent, can inflate inequalities, even if it supports economic growth.

The arguments on supply side inflation must also go once and all. Targetting core inflation, which increases the command and control of the SBP, can help to a great extent. The SBP may target non-food, non-energy or the average core inflation. This is necessary to do away with the “inflation was supply side” mantra and improve the SBP’s accountability mechanisms. The secondary legislation should, however, clearly indicate which indicator of core inflation will be targetted.

Targets under each objective of the SBP must be directly quantifiable and penned down in black and white. Take for example, the tertiary target of “Support[ing] Government’s economic policies to foster development and fuller utilisation of resources,” as proposed in the SBP Amendment Act 2021. This is absolutely vague. It should be replaced with a clear target, such as “maximum and sustainable employment,” like the Reserve Bank of New Zealand (RBNZ) has done.

This is important for at least three reasons. First, sustainable and maximum employment reduces inequalities of income. Second, it can guide the SBP to consider a policy mix that has favourable side effects. Third, it is directly quantifiable, hence provides a stronger basis for accountability.

Once the inflation target, with well-defined specifications, is agreed upon a clear accountability system must be put in place. The SBP Amendment Act 2021 appears to be inconsistent in this regard. It asks for exemplary independence with almost no accountability. The two cannot go together, for at least two reasons: first, monetary policy has serious bearings on day-to-day life of the people, therefore it cannot be left unchecked; second, after its strongly recommended independence is granted, the SBP to deliver with its monetary policy and must be held accountable if it does not. Secondary legislation must be introduced to put accountability mechanisms in black and white. These should address the following questions: What will be the process of accountability? Who will be held responsible for any deviations? What will be the acceptable explanations and penalties for unacceptable deviations?

The authorities must understand that central banking, particularly monetary policy, has significant distributional effects. It cannot be undertaken in isolation from its socio-economic consequences. To keep in line with modern practices in central banking and progress on the agenda of social footprint of monetary policy, the SBP has much work to do in areas of communication, research and decisions-making.

The writer is research fellow at the Sustainable Development Policy

Institute and heads its Policy Solutions Lab. He tweets @sajidaminjaved

The SBP and price stability