High inflation and the state bank’s eroding credibility threaten Pakistan’s growth prospects
Throughout history, a high level of inflation is one of the most pernicious phenomena that has led to the collapse of empires and the rise of authoritarian regimes. The debasement of the silver coinage, the denarii, by profligate emperors like Nero and Commodus has been attributed as one of the main causes of the fall of the Roman Empire.
In every economic condition, there are winners and losers, but with high inflation, the longer it persists, the harder it is to find any winners. High inflation hits lower-income families hardest because items such as transport and food make up a large portion of the household budget, leaving less for discretionary items of spending. The decreased purchasing power also results in households putting away less in savings. Although it is the poorest sections of society that are worst affected, the increased volatility in price changes distorts the whole structure of relative prices. The uncertainty about interest rates and profit margins makes it difficult for businesses to assess the future course of action. There is not only an increased likelihood of the misallocation of resources but also postponement or abandonment of investment decisions, which in turn can contribute to a slowdown in the investment cycle.
It is for these reasons that mainstream economists consider curbing high inflation as an essential condition for a prosperous economy. It was also the rationale for parliament granting the State Bank of Pakistan (SBP) autonomy with the primary mandate of ensuring price stability. An independent central bank was expected to conduct its monetary policy operations free from fiscal policy considerations. However, the SBP’s tepid rate hikes over the last several months suggest an unwillingness to exercise its autonomy.
The Monetary Policy Committee (MPC) of the SBP in its Monetary Policy Statement (MPS), on January 23, noted that “core inflation has been on a rising trend for the past 10 months.” Both rural and urban CPI is at an elevated level, which points to strong demand-related pressures. As reported by the Pakistan Bureau of Statistics, the Consumer Price Index continued to remain high at 24.5% in December 2022 year on year, having touched a 47-year peak of 27.3 percent in August 2022. This can be further seen in the expansion of domestic credit owing to a “seasonal rise in private sector credit along with increased budgetary borrowing.” The fiscal deficit, in the four months of FY23, increased to 1.5 percent from 0.9 percent of the GDP in the same period last year.
In every economic condition, there are winners and losers, but with high inflation, the longer it persists, the harder it is to find any winners.
Empirical evidence shows a strong negative correlation between interest rates and government borrowing from banks. As interest rates increase, net government borrowing tends to fall and therefore needs to be aggressively hiked to impose fiscal discipline. While the MPC claims that the current fiscal stance is “inconsistent with monetary tightening,” it nevertheless chose to increase the policy rate by only a modest 100 basis points to 17 percent. A hawkish stance such that the rate hike was above market expectations would have been more consistent with the SBP’s assertion “that it is critical to anchor inflation expectations.”
The SBP’s policy rate increases in the tightening cycle that started in September 2021 have consistently been behind the curve and have kept ex-post real interest rates, that is, lending rates adjusted for inflation, on average at negative 2.5 percent. The accommodative monetary policy stance of the SBP continues to drive real rates deeper into negative territory. This is in sharp contrast to the trend in the rest of the world. According to the IMF;s October 2022 Financial Stability Report, the short-term median real interest rate on a forward-looking basis in Latin America had increased to a positive 5 percent. Likewise, the median real rate for Asia and Central & Eastern Europe had increased to 1 percent and 3 percent respectively.
The central bank lacks credibility in its claim of wanting to ensure that “inflationary pressures are not entrenched that could feed into higher inflation expectations over a longer-than-anticipated period.” The slow response in taking corrective measures to curb demand has contributed to bolstering inflation expectations that are persisting and continue to be broad-based. As per the SBP’s survey of forecasters, the long-term inflation expectations continue to remain unanchored at close to 9 percent, which is above the stated objective of stabilizing inflation around 5-7 percent.
The risk now exists that to ensure price stability, the SBP will have to increase rates much more than it would have had to if it were to have demonstrated commitment to the primary policy goal. If forced to increase rates rapidly, it could lead to a recession. The economist, Fredrik Hayek cautioned that it is possible to prevent recessions by “preventing the inflations that precede them, but there is little we can do to cure them, once they have set in”.
– Javed Hassan is an investment banker who has worked in London, Hong Kong, and Karachi.
He tweets as @javedhassan