The monetary policy for the second half of this fiscal year is designed to attain price stability, considered one of the basic functions of a central bank.
The policy statement for January-June 2005 says that the State Bank will achieve this objective by further increasing the interest rates.
The financial market has responded to the policy statement and the bond yields as well as KIBOR or Karachi Inter-bank Offered Rates have moved up. In fact, the policy statement issued on January 19 followed a sharp increase in the average yields on three-month and one-year treasury bills has made it sound all the more meaningful.
But a million-dollar question is: will a tighter monetary policy to be pursued that can lower inflation significantly-and if so to what extent? The monetary policy statement has identified one set of factors that can fuel inflation further and another set of factors that can depress it.
Let us first examine the factors that can push up inflation numbers. The policy statement says continuation of growth in money supply and private sector credit may keep inflation up.
The latest State Bank data show that the banking sector lent a little less than Rs285 billion to the private sector in the first half of this fiscal year, exceeding the full year target of Rs200 billion.
A key reason for this unprecedented increase in private sector credit off-take was that average lending rates remained below inflation despite tightening of treasury bills rates by the SBP during July- December 2004.
Average lending rate in November 2004 stood at 6.61 per cent, far below the year-on-year inflation of 9.26 per cent in that month. Earlier, from July through October also, the weighted average lending rate in every single month stood below inflation for that month. Naturally, businesses borrowed heavily from banks.
It is reckoned that as the monetary policy for January-June has set the tone for further increase in interest rates, average lending rates should also move up but private sector credit off-take will not slow down unless average lending rates of banks rise past inflation.
Year-on-inflation in December 2004 was 7.37 per cent. Data on average lending rate of banks for that month are not available but speculations are that lending rate for December 2004 would average around 6.70-6.80 per cent.
At that level, net lending rate would still be negative but the gap between average lending rate and year-on-year inflation would be much smaller than in the past. When exactly the average lending rate would be higher than inflation, depends on the pace of increase in average lending rate and the pace of decline in inflation.
Indications are that the net lending rates would turn positive sometime in the last quarter of this fiscal year. But would that increase the average deposit rate also? That depends on whether banks are willing to keep the present rate of growth in interest income intact or increase it.
If they are ready to let the rate of growth in interest income fall or even keep it intact-and also manage to cut operational costs a little bit-they will be able to hand out much higher rates of return to the depositors in January-June 2005.
But if they fail to do this, then one should not expect a substantial increase in the rates of return on bank deposits. Average return on bank deposits stood at 1.21 per cent at end-November 2004 literally unchanged at the end-June 2004 level.
During this period the average lending rate of the banks went up by 12 basis points-from 6.49 per cent at end-June to 6.61 per cent at end-November. The monetary policy statement identifies pass-through of higher oil prices as another factor that can fuel inflation further during the second half of this fiscal year.
During May-November 2004, the government maintained a cap on domestic oil prices. But from December it started passing on the impact of higher international oil prices onto the local prices.
As this practice continues, there is little room left to hope that other measures both monetary and otherwise would lessen inflation substantially. The reason is that higher oil prices push up inflation not only by inflating the prices of the items grouped under Fuel and Lighting but also increasing indirectly the cost of almost all goods and services in the 374-item basket of Consumer Price Index or CPI.
It is also argued by some that the State bank needs to make its response to rising inflation more market based, moving away from the conventional mode of adjustments based on core inflation.
Central banks can define core inflation for different countries in different ways but it is generally believed that core-inflation is non-food, non-fuel inflation. Central banks often act when core-inflation has been on the rise, deferring an otherwise required tightening of interest rates if core-inflation is in check but overall inflation has been showing an upward trend.
The monetary policy statement says that the third factor that can lead to further rise in inflation is that the current account deficit may widen during the second half of this fiscal year.
Provisional data released by the State Bank show that in the first five months of the year, i.e. between July and November 2004, the current account deficit stood at $746 million, due primarily to a huge trade gap of $1.855 billion.
As the trade gap has widened to $2.409 billion during July-December 2004 and is set to reach an estimated $4.8 billion or more for this full fiscal year, the current account deficit for the full year would be quite substantial.
A large current account deficit fuels inflation by weakening the local currency, which raises the cost of imported goods thus contributing towards imported inflation.
Imported inflation, on the other hand, shows a quicker increase if the current account deficit is rooted primarily in trade deficit, which has been the case in Pakistan.
One way of keeping the rise in imported inflation is to cut down on the import of finished and semi-finished goods as well as such items like oil whose widespread consumption increases the prices of a vast variety of items.
Another way of keeping it in check is to keep overall balance of payment in surplus and stabilize the local currency through interventions of the central bank.
Our economic managers are focussing more on the second way out-the State Bank has been selling dollars to banks for financing oil imports since November 2004 and that has helped the rupee regain 3.4 per cent of its lost value against the US dollar.
But little or almost no effort has been made to limit the imports of finished and semi-finished goods (other than those that are used as raw materials in export-based industries) particularly food items.
Instead, Pakistan is going to spend hundreds of millions of dollars on import of wheat, sugar and fertilizers. At the same time, very little is being done to develop alternative sources of energy to cut down on imports of petroleum and its by-products.
Another factor that can keep inflation up is the rising trend in real estate prices, as identified in the State Bank's monetary policy statement. That real estate prices have been on the rise is a common knowledge but in the absence of official data it is not easy to gauge its direct impact on inflation.
But a year-on -year 11.67 per cent increase in house rent index of CPI for December 2004 provides a clue to this effect. Since house rent carries 23.43 per cent weight in the CPI, the heaviest after 40.34 per cent of food & beverages, the central bank has rightly identified the rising trend in real asset prices as a possible contributor to inflation in the second half of this fiscal year.
The prices of food & beverage group items increased by 7.88 per cent year-on-year in December 2004. Food & beverages and house rent combined have a total weight of 63.77 per cent in the CPI basket. So, inflation can be effectively checked if concrete steps are taken to lower the prices of the food & beverage group items and house rent.
The monetary policy for January-June 2005 can be helpful in this regard, if the financial market picks up a clue from it for faster increase in interest rates and begin to offer more to the depositors and investors.
That would depress the latter's temptation for employing surplus money in speculative areas of investment including real estate. On the other hand, the government should also take some bold administrative measures to curb hoarding of food items, which also is a key reason for the price flare-up in food & beverages items. Hoarding of wheat last year is an example.
Meanwhile, a couple of positive developments may also keep inflation in check. One of them is a rising production in large scale manufacturing coupled with the prospects of better performance of agriculture sector.
Large scale manufacturing output grew by more than 13 per cent in the first five months of this fiscal year and cotton crop may reach 14 million bales mark for the first time.
This huge cotton crop would surely add to the exportable surplus besides making cotton-based exports more competitive in the world markets. The monetary policy statement says that improved food supplies due to planned import of 1.5 million tonnes of wheat during this fiscal year may also dampen inflation. (One million tonnes have already been imported).
Weighing the factors that can push up inflation and those that can keep it in check, the State Bank's own projection of 7.6-8.2 per cent for this full fiscal year, against the initial target of 5 per cent, may be closer to reality.
The central bank had included this projection in its first quarterly report for the current fiscal year but understandably it did not make any such projection in its monetary policy statement. The SBP would come up with a new projection for inflation in its second quarterly report to be released in late March.
