Jan 3 - 9, 20

Apparently in a bid to switch over from State Bank borrowing to commercial bank, a rather unusual feature was accepting T-Bills bid worth Rs95 billion against a stated pre-auction target of Rs15 billion. However, ample liquidity in the system results in nominal increase in cutoff yields. According to some critics, SBP may have agreed to a one-off violation of the target as the government was faced with a payback of Rs70 billion on maturing T-bills, plus interest, but, in the next quarter, adhering to pre-auction target would be more appropriate.

The difference between SBP's policy rate of 14 per cent and government T-Bills yield is now less than 50bps. This is indicative that SBP would be further enhancing its rate at the time of announcement of Monetary Policy Statement early January. Caught in a political turmoil, the government has failed to either raise revenue, or cut expenditure - as a result the budgetary deficit has crossed 7.5 per cent. The consequence for this is expected to hit hard after a time-lag of six months, coupled with high oil prices, inflation could easily cross 15 per cent.

The debate regarding role of monetary policy in ensuring macroeconomic stability in general and price stability in particular has been intensified. While it may take some time before a consensus emerges on the appropriate monetary policy strategy, almost all economists and central bankers in global policy circles, whether they favor or criticize the current monetary policy stance, still believe that containing inflation is and should be the fundamental objective of monetary policy.

In Pakistan, a similar debate on causes of inflation and role of monetary policy has intensified. Most observers agree that inflation, which is persisting at a high level for almost three years now, is one of the major economic issues currently faced by the country. However, they are skeptical about the effectiveness of monetary policy in bringing it down. Some commentators believe that it is entirely a 'supply-side' phenomenon and monetary policy cannot play any role in containing inflation. Others cite fiscal weaknesses and the large budgetary deficit as the main reason for inflation and point out that monetary policy cannot influence the behavior of the government.

In such a backdrop, understanding the logic of newly appointed governor of the central bank is necessary. In his keynote address at FPCCI, he tried to share with business community his thoughts and perspectives on this important topic. He said: "SBP firmly believes that implementing a coherent strategy for monetary policy may not be enough if the elements of the strategy are not sufficiently well communicated or understood, and if the responsibility for the outcomes of the monetary policy stance is not clearly delineated."

He also tried to elaborate three conceptual points: 1) the process of price determination at the basic level; 2) the behavior of inflation and 3) understanding the trade-offs faced by policy makers.

He was of the view, "If the productivity is low and declining, then the final price tends to be higher even if the cost of acquiring the factors of production remains the same. Put differently, the price can be kept stable or even reduced by increasing the productivity of workers and better and efficient use of technology. The monetary policy stance geared towards containment of overall inflation and thus stability of prices eases the pressures on the cost of production but cannot increase the productivity."

Another point highlighted by him needs to be understood very clearly. He said: "Similarly, deterioration in the external accounts, either because of a large gap between payments and receipts or lack of funds to finance it, cannot continue without an adjustment in the exchange rate. Attempts to maintain stability in the exchange rate by supplying the required foreign currency cannot be achieved on a sustained basis without interest rate increases. The reason is because injection of foreign currency by a central bank, when the outflow of foreign currency in the country is greater than the inflow, requires purchase of domestic currency in exchange. This reduces availability of liquidity of domestic currency, which pushes up market interest rates. To ease the liquidity pressures, the central bank can inject the domestic currency through its normal Open Market Operations. However, this strategy becomes difficult to maintain if the foreign currency outflows continue to remain higher than inflows and if the domestic inflation starts to increase because of ample availability of domestic currency."

The point he was essentially trying to make was that for a policy decision to be effective adjustment in some area of the economy are required. If the required adjustments are not taking place or if there are other policies that are diluting or neutralizing it, then the credibility of decision makers suffers, leading to uncertainty. What is required is that policy makers articulate an agenda of priorities for the future of the economy, communicate it to the public, develop political consensus, take timely and coordinated decisions, and implement the agenda over a number of years. Delays or uncertainty in any aspect of this strategy results in less than desirable outcomes making the trade-offs among key priorities tougher.

The governor may be right but unless the elected representatives, policy planners and the central bank enjoy complete coherence, neither the inflation will be contained nor any reduction in interest will be possible. The bottom line is interest rate in the country must be brought down to facilitate creation of new productive facilities for accelerating GDP growth rate and poverty alleviation.