DOES HIGHER INTEREST RATE REALLY HELP CONTAINING INFLATION?

HASAN FUAD, ASKARI LEASING LIMITED
Nov 23 - 29, 2009

Central banks all over the world think that the panacea for controlling a run a way inflation is always jacking up of interest rates and the SBP is no exception.

Does it really work? Does it really achieve its objectives?

Let's try to examine the issue.

The economic goal of each government around the globe is the optimal utilization of economic factors of production which are land, labor, money and entrepreneurship, thereby promising a sturdy economic growth by way of enhancing trade and economic activities.

The central bank, as an independent government financial body, is given the objective of maintaining the money supply at a level that accommodates a steady growth in the Gross Domestic Product (GDP). This objective is achieved by way of sustaining an orderly financial market and juggling the conflicting goals of steady economic growth, low unemployment and low inflation. In this regard, a central bank is required to maintain a low rate of inflation as an overriding goal of its monetary policy.

The technique of monetary policy is used to increase or decrease the money supply in the economy. It is less disruptive as compared to the fiscal policy, making it easier and quicker to implement given that adjusting the money supply does not require governmental endorsement.

Central banks perceive that inflation is caused by the increase in money supply in the economy whereby too much money is chasing too few goods. If the quantum of money is reduced, there will be a new equilibrium in the economy where prices will be established at a certain level and will not continue to grow. Central banks can condense the money supply by elevating interest rates and then selling their securities, i.e. treasury bills, resulting in withering the money supply and thereby warding off inflation. In other words, interest rate as the price of money, when increased, eventually increases the money's worth. This tends to control the increasing inflation rates as money's value, i.e., its purchasing power, increases.

Money is created by the banks through a fractional reserve system. By way of a tighter monetary policy, the central bank controls the velocity of the money in the economy. This results in higher interest rates and a lower inflation. But does it always work? This is the question.

Over the years, inflation has always been a challenging issue for the SBP. Depreciation in the value of rupee not only depresses its exchange rate in the international market (hence raising the Balance of Trade deficit) but it also raises the level of poverty within the country as a household can buy less with the income available.

On a yearly basis, the inflation rates were higher than projected since it reached at the highest increase of 24.64% during the fiscal year 2008-09. The Consumer Price Index (CPI) continued to report an increase, causing to slowdown the growth in the country's GDP at a minute 2.5%. To curb the ongoing wild increase in inflation rates both in food and non-food items, the SBP increased its discount rate in July 2006 to 9.5%. The discount rate continuously kept on showing an increase over the years ahead till it reached at 15% in November 2008.

Considering the Sensitive Price Indicator (SPI) as a measure of inflation rate, it is formulated by a basket of 53 items, ranging from basic food items such as wheat, rice, sugar, garlic and various non-food items such as match boxes, petrol etc. Prices are averaged in a number of cities belonging to all four provinces. These prices are developed into a price index which is monitored on a weekly, monthly, quarterly and annual basis. So, one can observe the change in the price index on a periodical basis. The SPI showed a stunning increase of 32.64% during the fiscal year 2008-09, against an increase of 10.84% during the fiscal year 2007-08. This is mainly due to administrative issues in the supply chain of food items like hoarding and reduction of supply of those items.

Keeping in view the above discussion, it is quite obvious that the SBP's tight monetary policy was not quite able to sustain the inflationary pressure on the economy. The reason for this disappointment is that the increase in interest rates raised the cost of financing for both households and industrial borrowers, thereby causing to slowdown the economic activities. Subsequently, the cost of production increased which resulted into cost-push inflation in the country as the industrial producers raised prices to maintain their profit margins.

Some analysts say that there is no economic problem with our country. The only concern causing the sluggish economic growth is the lack of good governance. Our country is affluent in all factors of production; however, the optimal utilization of these resources has never been possible due to lack of good governance. Certainly, the corruption has its own cost which adds to the cost of doing business. Furthermore, such administrative issues in the supply chain of food items caused food inflation to strikingly rise thereby making the SBP's tight monetary policy less effective and economy to grow in a slothful manner. A developing country like Pakistan is supposed to have a growth rate of 9-10%, however, we have been averaging around 2-3%. With a population growth of 2-3% per annum our economy's growth is totally wiped out. In reality, we are not growing at all. The resources are not being used efficiently.

Further, our goal should be to enlarge our exports volume so as to bring our BOT deficit down to a level which contributes to our GDP rather to eradicate it. Tight monetary policy, as discussed above, has only caused to hoist the cost of production which is a major aspect in decreasing the volume of exports. For that reason, to accelerate the economic activity in the country, the SBP should maintain the interest rates to a level which favor the private sector producers. Another issue relating to our GDP deficit is the war on terror which is costing us a lot. Yet, the country who led us to this war has promised an annual aid of USD 1.5 billion, which is far less than what is required to support our economic loss on this war. On the other hand, our exporters and export-oriented industrial sectors do not have access to the international markets due to some domestic issues as well as refutation from the aid-granting nation. This seems like a twofold policy for a developing country like Pakistan. Accordingly, our exports will not grow, and as a result, our BOT will remain in deficit. In this regard, keeping a tighter monetary policy intact is not worthwhile.