INTEREST RATES AND INFLATION

(WHAT IS THE EXACT RELATIONSHIP BETWEEN THEM, ESPECIALLY IN PAKISTANI MARKETS)

MULAZIM ALI KHOKHAR,
RESEARCH ANALYST
Feb 25 - Mar 02, 2008

INTRODUCTION

Money is known to be the blood in any economy, while the Central Bank proves to be the heart which controls the supply, and commercial banks and other financial institutions play the role of valves and veins of the system through which the blood (money) supply is provided to different part of the body (sectors of economy).

Here, interest rate verifies the role of antibiotic pills which discourages the bad sectors (profiteers) and gives some rest to the body (economy). This is the best tool available with the central banks (the doctors of economy) to control the money supply in the financial system in the short spam of time. Whilst, inflation is like "blood pressure" ailment which always remains in the body but remains stable until one takes the prescribed doses.

First of all, before going in the analysis of the medication (interest rates and inflation), we should know the reasons of inflation. Broadly speaking Inflation has two main origins; first the demand pull and the second is cost push. Thus inflation is caused due to escalating demand or due to shortage of supply.

Demand pull inflation emanates from higher money supply in the economy. People having more money to spend feel rich and spend more and are willing to pay higher prices. This encourages profiteering and the prices get momentum to the north. In tandem, the Cost-Push inflation originates from the fact of hiking costs of production (energy, oil and imported material prices), which contribute to the reduced supply of goods and services and results in inflating prices.

Pakistan is facing both the demand and supply pressures at the same time; demands have touched skies due to ready availability of consumer loan while costs of production are on a continuous hike due to increasing energy shortage and globally increasing oil prices (oscillating in the band of $90-$100).

The situation looks quite fuzzy; the money supply is much higher which signals for the control, while the interest rates increase results in increased costs of production.

Here one bluntly questions that is the interest rate increase a right decision? The answer to the question is very vague! No one can exactly measure the impacts as they are vast and distinct on different sectors of the economy.

GROUND REALITIES

Inflation is already touching skies as our recent CPI rates are floating at and above 8.8% which is way high than our stated targets and is 25.7% higher than last year figures of 7%. Although the figures confirm it to be less than the corresponding period last year CPI of 8.9% by 1.12%. Currently our food inflation index is inflating at a weekly average rate of 18% and the half year figures are also in double digits at 12.2%. [See Table # 2]

DISCOUNT RATES

To curb these inflationary pressures, State Bank of Pakistan has been applying the tight monetary policy for the last few years and it has further tightened it amid new wave of mounting food and energy prices, increasing the discount rate to 10.5% by 50 basis points up till recently, curbed money supply. But as the changes are taking place at very level, this does not bring much change to the existing inflation figures. [See Figure# 1]

The discount rate hike has failed curb the inflation but have brought some changes in money supply. The recent M2 growth has been 5.77% standing at Rs.234.4bn as on 19th January FY08, while the M2 growth as at 1st July FY08 was 5.87% with Rs.199.8bn. the recent reserve money growth declined to 9.6% from 16.63% at Rs.116.2bn from Rs.166.5bn. [See Table# 1]

Its failure is the result of the facts that the banking spreads have always been higher and have witnessed very minimal change over the years and banks are given free hand to determine their rates. Thus, banks find it very attractive to loan out their reserves over and above the statutory liquidity requirements.

ECONOMY AND FACTS

The facts stat that the GDP is consistent of 27% of industrial production, 54% Services production and 20% agricultural production. Main industrial sectors like textile and other large and small scale manufacturing are heavily indebted and during the recent oil, energy and political crisis in the country, which has already increased unit cost and reduced supply, increasing interest rates means further increase in their cost. This will surely result in inflation, which is surely not taken in account. Our agricultural sector is already under performing and the loan holders are poor people. Increasing rates will mean further aggravation of their rights which will increase the daily agri-goods.

INTIMIDATIONS AND NEEDS

Government needs to take notice of increasing production prices of the industrial sector so as to maintain the growth pace. Agricultural Sector needs extra benefits, very favorable loan structure and reduced interest rates. Need to have checks and balances on exports, where most of the favorable financial stances are provided to the investors.

The existing pressures on inflation will not settle and tight monetary policy containing higher interest rates will not benefit until the supply side pressures on the inflation aren't cut back. Government needs to apply a policy where proper estimates of domestic demand are made and exports are kept subject to surplus supply only. Giving out the domestically needed goods and services will not benefit the country. It may bring some favorable economy results in particular periods but will be a flop in the long run.

Hope the Central Bank and our Export bodies and Government budgetary planners, all collaborate and form a monetary and fiscal policy which creates positive results, other wise one sided actions will always bring some other imbalances.

TABLE 1

MONETARY AGGREGATES (FLOWS)

ACTUAL

1-JUL

19-JAN

billion Rupees

FY07

FY07

FY08

Money Supply (M2)

658.3

199.8

234.4

Growth

19.3

5.87

5.77

Annualized growth

-

13.6

19.2

Reserve money

209.1

166.5

116.2

Growth

20.9

16.63

9.6

Export finance scheme

26.8

25.6

-35.9

SOURCE: SBP


TABLE 2

INFLATION INDICATORS

FY07*

1H-FY07

1H-FY08

CH. TO 1H-FY07

CH. TO FY07

CPI

7

8.9

8.8

-1.12%

25.71%

Food group

9.7

12.7

12.2

-3.94%

25.77%

Non-food group

5.1

6.2

6.3

1.61%

23.53%

Non-food non-energy

5.7

5.7

7.2

26.32%

26.32%

20% trimmed

6.5

6.3

8.7

38.10%

33.85%