Feb 15 - 21, 2010

In Pakistan, over the past few decades, the relationship between inflation and economic growth has drawn extensive attention of macroeconomists, policy makers, and the central bankers of both developed and developing countries.

Specifically, the issue that whether inflation is necessary for economic growth or it creates negative impact on the economy. Few of the monetary policy makers in Pakistan believe that moderate and stable inflation rates promote the development process in the country, and hence reasonable economic growth. As a matter of fact, moderate inflation supplements return to savers, enhances the investment, and therefore, accelerates economic growth in the country.

In Pakistan, out of two very important factors during drafting of monetary policies one factor is mostly ignored i.e. taking into consideration that the inflation rate is not indexed in the salaries and wages, inflation will lead to a decrease in the purchasing power and an increase in the cost of living of an ordinary man. Second, given that the Pakistan frequently has to balance the credit requirements by the private and public sector against both inflationary and balance of payments pressures, it is not always possible for the State Bank to adjust the nominal interest rate above the expected (or actual) inflation rate through monetary policy.

It is said and believed that policy makers in Pakistan understand the factors that drive inflation are fundamental to designing monetary policy. Certainly in the long run, inflation is considered to be always and everywhere a monetary phenomenon. In Pakistan, increase in the wheat support price has been blamed for inflation for years. If inflation is a monetary phenomenon, then it is the responsibility of the State bank and the fiscal authorities to achieve the price stability. If inflation is caused primarily due to increase in the wheat support price, then Ministry of Agriculture should play a key role in containing inflation.

After remaining relatively low for quite a long time, the inflation rate in Pakistan started to accelerate in late 2003. Following the 1998/99 crisis, inflation was reduced to below 5 percent by 2000 and remained stable throughout 2003. Tight monetary policy appears to have contributed to this low inflation environment. With monetary growth picking up, inflation followed and increased sharply in late 2003, peaked at 11 percent year-on-year in 2005; whereas from 2007 Ramazan till today, inflation is in double digit however for a brief period it was in single digit.

The expansionary economic policies of the government and the SBP over the last few years resulted in the improvement in various macroeconomic indicators including Gross Domestic Product (GDP) growth, economic bubble bust in recent past. Despite this short-lived impressive performance of the economy, some worrisome factors have also appeared on the scene. The most significant of these factors is inflation, which remained above 10 percent during the last two years in particular. Several supply and demand side factors could be responsible for this surge in inflation. Inflation can be a result of shocks to the supply of certain food items and to world oil markets. Rising oil prices can pose risk of increase in prices of almost all other commodities of the consumer basket. Such supply-side shocks are very volatile and can cause large fluctuations in food and oil prices. The effects of this on overall inflation at times can be so excessive that these cannot be countered through demand management, including monetary policy. However, greater emphasis in the recent debate on inflation remained on the demand side factors.

The demand side pressures are often considered as an outcome of 9/11 accident in the United States of America (USA) and a combination of expansionary monetary and fiscal policies. First, increased domestic demand due to remittances from abroad and liberal demand-management policies outpaced the domestic production, creating a positive output gap, which in turn put upward pressure on prices. Growth in private consumption remained above 10 percent on average during Musharaf regime, depicting signs of demand side pressures on price level.

Second, the growing gap between domestic demand and domestic production was filled by a sharp increase in the net imports, which grew by over 40 percent in FY05 and by 24 percent in FY06 and 20 percent in FY09. In comparison to imports, exports increased by only around 10 percent in FY05 and by 13 percent in FY06 and around 7 percent in FY09. This resulted in a record increase in the trade deficit. A rising trade deficit can be a cause of expectation of high inflation in future.

Third, fiscal policy has remained expansionary in the last few years. Because of expansionary fiscal policy domestic demand increases and pressurizes the current account deficit, resultantly widens the investment-saving gap. Moreover, printing notes to fill the gap adds inflationary pressures. On the other hand, government borrowing from the SBP also increases, which again has serious consequences on the general price level.

Fourth, the expansionary monetary policy through high growth in money supply and loose credit policy is the factor which increases the inflation.

Rising import prices are also considered as an important factor in creating inflation. The exchange rate is putting upward pressure on price levels. Similarly, some people blamed indirect taxes as the main cause of inflation. The question now arises as to what were the most significant explanatory factors for recent inflation trends in Pakistan?

However, the most significant factors are private sector credit and imported inflation. Overall impact of fiscal policies on inflation is not that significant and rather the direct part of taxes was dominant in putting downward pressure on prices. Government sector borrowings also are contributing the rise in prices. As of today, exchange rate (dollar and euro) is the biggest factor in Pakistan and going forward will definitely contribute significantly in building up the inflation. It is forecasted that by the end of 2010, dollar will touch 100 which is nothing but devastating. However, the role of wheat support/procurement price and the other subsidies are insignificant.

People's immediate concern is with how their incomes hold up with changes in their expenses. Businesses are thinking about how to co-relate the prices of their products with their costs.

Recent 6 rupee oil shocks resulted in high inflation. But equally damaging was the relative price change. A slight change in oil prices brings huge change in the prices of every product. Economists in Pakistan tend to emphasize that inflation can do economic damage by distorting investment and consumption decisions yet they are apparently helpless in controlling it.

As a matter of fact, Pakistan's economic polices are on wrong fundaments therefore nothing can be changed unless and until those fundamentals are corrected.

The main concern that emerges out is whether it is possible to control the inflation in Pakistan. Would the policy makers be able to control the flow of credit to nonproductive sectors and to profit seeking activities? Is the policy of subsidizing food items through the government-run utility stores a successful venture or would it be another episode of mismanagement. What is the real usefulness of money support programs? The biggest contributing factor in food inflation is bad governance and mismanagement while other inflation can be curtailed through better polices and growth in GDP.