SINGLE DIGIT INFLATION BECOMING A DREAM

NURSE KHURSHEDI
(feedback@pgeconomist.com)

June 25 - July 1, 20
12

Inflation in Pakistan had been insignificant for quite a long time until 2003. However, since then it started galloping. In 1960s, an average inflation rate was 2.6 per cent in terms of whole price index (WPI). In later decade, however, it shot up to 12 to 18 per cent due to currency devaluation and flood. Pakistan regained the single-digit in 1980s and during the first three years of 1990s, except 1990-1991 when it was 11.7 per cent due to Gulf War. In 1994-95, WPI and consumer price index (CPI) showed a sharp increase and reached to 19 pct and 13pct respectively. Inflation came down to even below five per cent in 2000 and sustained low until 2003. This low rate was the result of tight monetary policy.

In late 2003, monetary growth picked up pace and as a result inflation rate rose to 11pct. However, by September 2005, inflation stabilized up to some extent and stayed around 8-9 pct. In 2008, Pakistan had faced the worst inflation rate of 26.79 pct. However, it dropped to 14.2 pct in 2009. In June 2010, the inflation was recorded as 12.69 pct and currently inflation rate is 11.30 pct. Pakistan has experienced the drastic inflation rate of 25.33 pct in august 2008 and lowest inflation rate of 1.41 pct in July 2003, which was a record in Pakistan's history. The average inflation was recorded at 10.15pct from 2003 to 2010.

Inflation is considered as cost-push and demand-pull. When the aggregate demand of goods is more than the aggregate supply of goods, it is called demand-pull inflation. When supply of goods of particular sector falls short for a long span, its prices go up and it becomes a major cause of inflation in economy. This is called cost-push inflation.

Three more theories have also become famous. According to the first one, inflation is always and everywhere a monetary phenomenon and it demonstrates that monetary policy plays important role against inflation. Second, there is a trade-off between inflation and unemployment i.e. there cannot be high unemployment rate and low inflation rate at the same time and third theory says growth of production, wages and income flexibility are important drivers of inflation.

These theories are, no doubt, milestones in understanding the factors behind inflation but these theories are not adequate especially when we talk about Pakistan.

According to Pakistan Institute of Development Economics (PIDE), increased prices of food, fuel, raw materials and finished goods, expectations about inflation, and GDP in relation to growth of supply of money are the key factors behind inflation, in which food prices ranked at first, inflationary expectations as second, and money supply as third (and less important). There are many other factors like indirect taxes, high prices of agricultural support, currency devaluation, rise in utility prices, power shortage, rise in salaries and infrastructural problems, which contribute to high inflation rate.

Along with this, growth of money, rate of interest, the GDP (real), the rate of exchange and supply side are monetary factors which are also the main determinants of inflation in Pakistan. In terms of impact of exchange rate, there are some relation between inflation and exchange rate through empirical studies because inflation rate appreciates the real rate of exchange thus it erodes the competitiveness and results in pulling of exports and ultimately balance of payment is disturbed. Monetization (conversion of fiscal debts into available currency) triggers inflation. In case of Pakistan, structural reforms introduced by IMF also result in inflation. To increase productivity, we have to raise wages and salaries.

Generally, a sudden change in price of goods causes inflation.

The demand exceeds supply in Pakistan due to energy crises, sick industrial units, shortage of material and lack of trained labours etc. If all the other factors remain same, then this factor is beyond the limit of government and government has no direct control over it. In general, the effect of tax rates is considered indirectly related to deficit budget, but the impact of excise duty and sales tax is in fact direct on finished commodities as well as on raw materials. The tax rates have been increased in Pakistan and on some commodities even value added taxes have been charged. If government imposes more taxes on goods, then producers normally transfer the burden of taxes on to the customers. Consequently, the selling price of goods increases which pushes the inflation level up. Government purchases some commodities especially wheat, cotton and sugar at high prices than the price prevailing in the market to provide support or encourage farmers. This act, on one hand, provides subsidy to people and on the other hand, it violates the criteria of efficiency and hence the general prices increase.

Another major cause of inflation is rapid increase in circulation of money, as it increases the demand for goods and services. Monetary authority is authorized to control the inflation by stabilizing the prices of commodities and by giving necessary guidelines to the commercial banks.

Pakistan imports lot of goods from other countries and being a small open economy (SOE), our domestic economy cannot escape from the after effects of rise in prices internationally. This problem becomes worse when we have to import raw materials and our national currency is devalued, as we have to accept the international prices as offered. This external price shock leads to high prices of domestic commodities and hence inflation.

Pakistan has been facing the problem of unemployment and brain drain for last few years. The number of overseas Pakistanis is getting large day by day. The remittances are also playing major role in creating inflation in Pakistan. High remittances mean more money with the people and more money means more demand of goods, and more demand means high prices of goods, which lead to inflation.

Population growth rate has been high and more population demands more goods but unfortunately, government has been unable to provide enough commodities to people which result in demand-supply gap and ultimately inflation.

The black money earned through smuggling, tax avoidance etc. increases the demand for luxurious goods, which also results in inflation. The consumption habits of the people also lead to inflation. When people buy more and more, demand increases.

Pakistan has been the victim of deficit budget. Budget experiences deficit when government expenditures are more than its income. It is estimated that if deficit budget increases by one per cent, it increases general price level by 6-7 per cent. To fill up the gap, government prints notes or finances it by borrowing from banks. This action of the government increases supply of money and hence leads to inflation. Increase in cost of production leads to increase in the prices of goods.

Production cost may increase due to increase in labour cost. When labour cost increases, it leads to increase in cost of production, which is eventually passed on to the consumers. Capitalism is also considered as a cause of inflation because it enables rich to get richer at the expense of the poor.

It is a high time that government and economists try to control inflation. Inflation rate in between three or four or maximum eight per cent can have a positive impact on our society nationally and internationally. In this way, salaries and wage rates will increase. But if inflation keeps on increasing in such a way that it crosses the positive limit, then it will be harmful for the economic life. Inflation is considered as one of the major obstacles in the development of any country.

Government can control the inflation by demand management policies, which include minimizing the borrowing and deficit budget, pacing the growth of money supply with the growth of nominal GDP, and maintaining fair rate of currency depreciation. In fact, general prices of commodities are reduced by 4.6 per cent if GDP is increased by 10 per cent.

The state bank of Pakistan (SBP) should guarantee price stability and promote growth in the country. Canada and New Zealand made the central bank independent to control the inflation with a clear mandate to stabilize general prices.

The main objective of the SBP should be price stability. In principle, the SBP could also target an exchange rate level as a nominal anchor to achieve macroeconomic stability. However, this implies adopting the anchor country's monetary policy and may yield a suboptimal rate of inflation. In addition, the exchange rate would no longer be available to offset the impact of external shocks on the domestic economy. The SBP is fully capable of implementing its own independent monetary policy consistent with the needs of the domestic economy. Maintaining price stability will ultimately be the best policy contribution to sustained growth that the SBP can make. While there may not be a trade-off between inflation and growth in the short run, it certainly exists in the medium- and long-run.

Finally, monetary policy has to be forward-looking to achieve its inflation target. Current monetary conditions affect inflation with a lag of around 12 months in Pakistan. There seems to be a stable relationship between private sector credit growth and inflation 12 months from now. In addition, there is also a relationship between broad money growth and inflation 12 months from now. Therefore, the SBP should set monetary policy today with a view to meeting its inflation target around one year from now.