FALLIBILITY OF POLICY RATE IN CURBING INFLATION

SHAMSUL GHANI (feedback@pgeconomist.com)
Feb 15 - 21, 2010

Today's most important economic lesson is that the textbook economic theories tend to be self-refuting. It is after the passage of a few decades, when the efficacy of a certain economic model based on this or that economic theory becomes almost irrefutable, that the bust phenomenon takes place. After the clearance of ensuing debris, the policy scanning job is undertaken and flaws are highlighted. An alternate economic policy design is evolved and put to use. The proponents of the new policy design see the new ideas working wonder and start gloating about the supposed infallibility of the new economic model.

The lessons of the past are forgotten when economy booms. Adam Smith economics came under the scanner after the great depressions of 1930. The Keynesian idea of government intervention through deficit spending and scientific market regulation had currency and the global economic managers waited in leisure for the Nixon-Reagan-period stagflation to surface.

US president Nixon, a free market proponent, had to pay a heavy price when out of political exigency he had to freeze prices and wages to control inflation, which in fact was essentially the outcome of a prolonged Vietnam war. This ill-timed measure was backfired raising doubts about the Keynesian model. The black Monday of 1987 when the US stock market plunged to a record level of 26 percent in a single day made the horrified economic managers go into a huddle once again. The Chicago school free market economist, Milton Friedman waiting in the wing with his explosive global economic theories came to the fore and replaced Keynesian economic model with his own that advocated operation of US economy at full employment level with the shifting of excessive US production to the new markets particularly those of developing economies. It was Friedman's rapacious economic model that US followed since the later part of the Reagan era till the end of George W. Bush, Junior's recently concluded eight-year term. The urge to find new markets lured the US financial sector into developing their in-house subprime mortgage market that triggered a global financial sector bust of colossal magnitude. Efforts to come up with some new, long lasting and sustainable economic model are perhaps still on.

The lesson is that no economic model based on certain economic theories can work equally well for all economies irrespective of their economic, geopolitical, cultural and educational conditions. Fiscal or monetary policies of a nation cannot be spelled out in its economic textbooks; which have to be designed with a creative and visionary mindset that allows for quick adjustments as and when required.

Inflation can be controlled by raising interest rate is like assuming that all types of fever can be treated with a single antibiotic. Policy rate management has an altogether different perspective for developed economies with huge bonds and financial derivative markets. At societal level, economic rationalization through high interest rate is more relevant to societies living on loans and mortgages. Our consumer finance and house finance levels never reached even a fraction of those prevailing in the developed economies. No doubt, during 2004-07, these levels went a few notches up, yet the harsh policy of hiking the interest rate, in successive moves, from 7.5 to 15 percent was nothing but mindless implementation of textbook theories.

According to Alan Greenspan, the British economist Lord Keynes regarded unemployment and inflation as two kids on a seesaw, but the situation of stagflation arising during Nixon era proved him wrong. Pakistan's monetary policy managers too look obsessed with the efficacy of high interest rate taking it as a panacea for all types of inflation. The real economic situation has proven them wrong but they are yet to admit it.

SBP failure to scale the key policy rate further down in last announcement has stunned the business and industrial circles who were expecting some relief on cost-of-doing-business side. In its monetary policy statement, SBP mentions resurgent inflation, fiscal slippages and oil prices as main reasons behind the decision to keep the rate unchanged. The fiscal slippage issue is purely an administrative matter to be dealt with by the government. Global oil prices are staying range-bound since long. Moreover, it is the government job to reduce dependence on oil and develop alternate energy resources. Inflation is more a function of administrative policies rather than the SBP monetary policy stance.

Profiteering, hoarding, cartelizing, and smuggling are the administrative areas that government is expected to pay attention to. On economic policy side, the IMF debt trap and the enforced subsidy management adds fuel to the inflationary fire. The recent uncalled for increase in petroleum products and energy prices are the force behind inflation resurgence, which cannot be checked by SBP tight policy stance. SBP could have neutralized the situation through a 100 bps rate cut to boost business and industrial activities. Surge in private sector credit and reduced pressure on cost of doing business would have certainly checked the building up of fresh inflationary waves.

The CPI has risen 10.8 percent during the first seven months of the current fiscal year. It was during the month of January alone that the CPI went up by 13.7 percent, which is clearly indicative of the effects of the current increase in electric and petroleum products prices. This increase has pushed the fuel and lighting index up by 20.2 percent. Food inflation during January increased by 15.5 percent. Food, fuel, and lighting prices will rise much more than the general level of inflation. This demonstrates that it is government's agricultural, energy and administrative polices that need to be revamped to check the resurgent inflation. SBP should not kill business and industry by assuming that it can control inflation with a high key policy rate. Further, SBP would do well to remove the glaring key rate anomaly vis--vis the other regional economies. It should endeavor to bring the rate down to single digit within the next six months instead of trying to control inflation, which is peculiarly immune to tight monetary stance.

WHOLESALE PRICE INDEX BY COMMODITY GROUPS

GROUPS

GROUP WEIGHTS

INDICES

DEC-2009 NOV-2009 DEC-2008
General 100.00 221.43 220.98 192.62
Food 42.12 235.06 236.69 210.77
Raw materials 7.99 226.19 208.71 169.18
Fuel, lighting & lubricants 10.29 290.11 294.39 231.18
Manufacturers 25.87 152.91 150.65 137.80
Building materials 4.73 186.76 187.33 213.13

The wholesale price index, which is representative of business and industrial activities highlights the ill effects of a high interest rate policy. The WPI recorded an overall increase of 14.96 percent during the last calendar year. Ignoring the high base effect, this increase might appear "not so upsetting" to the uninitiated. What is highly upsetting is the fact that during the same period the costs of raw material and fuel including lighting & lubricants went up by 33.7 and 25.5 percent, respectively. This shows how badly the business and industry have been hit during the last year. This happened in spite of a 250 basis points cut in the interest rate. The foregone conclusion, therefore, is that the business and industry are not going to respond positively unless the key policy rate is reduced at least to a single digit.