The SBP annual report 2005-06 claims that the CPI decelerated from 9.3 per cent (FY-05) to 7.9 per cent (FY-06) mainly due to monetary tightening to soften demand pressures as well as administrative measures to counter supply shocks.

In the aftermath of 9/11, lax monetary policy was followed in the fiscals FY 03, FY 04 and FY 05 resulting in high growth in the cheap bank credit to the private sector which in turn raised the inflation level to 9.3 per cent by the close of FY 05. At this point of time, the SBP began to tighten the monetary policy from July, 2005 by raising the interest rates.

The current status of the monetary/ credit expansion is summarised in the Table “A” .

It will be seen from the Table that monetary expansion [M 2 ] in FY-06 was much higher than the credit plan target despite the tight monetary policy. Likewise, credit to the private sector in that fiscal was also much higher than the credit plan target.

However, in the first eight months (July 2006-February 2007), the signs of decline in the monetary / credit growth is visible. This situation can be examined from two angles: (a) whether the fiscal year will close with the same trend or will the trend reverse in the last quarter? and (b) whether the decline in the credit growth owes its origin to the tightening of the monetary policy or some other factors are also involved?

Whether the trend will be reversed or not in the final quarter, much will depend on the inflows from abroad. In case of privatisation, proceeds are credited to the SBP’s account which raises its NFA [and consequently M-2] while credit of rupee equivalent of such proceeds to the government constitutes merely creation of money. Similar will the situation if, in view of large inflows from abroad in the financial sector including the banks and exchange companies, SBP makes purchases of foreign currencies from them to augment the reserves.

The monetary tightening may not be the only reason in lowering the quantum of bank credit to the private sector. The SBP report for the second quarter of FY-07], inter-alia, indicates that during July-January,2007, the credit growth in the following sectors has decelerated: (a) fixed investment loans in textiles (b) agriculture (c) consumer loans, (d ) commerce and trade and (e) manufacturing sector-mainly the sugar sector.

The deceleration in the credit growth in the textile sector cannot be co-related to the tightening of the monetary policy as the SBP has since allowed this sector to avail of short- term, as well as the long- term loans for fixed investment at the concessional interest rates; not only that, SBP has also allowed this sector to swap the high priced long-term loans with the low-priced ones. It is basically the sizable increase in the installed capacity, which has already taken place, in the textile [also in the cement sector] which has reduced the demand for credit.

The growth in demand for loans in the consumer sector may have decreased because of rising interest rates (tightening of monetary policy) limiting not only the capacity of the potential borrowers but also that of the existing ones who may be feeling uneasy in meeting their repayment obligations. It is also possible that in this sector too, the saturation point may be very close.

Simultaneously with the tightening of the monetary policy, SBP has been catering not only to the entire credit requirements of the government but was also providing funds to the government for retiring commercial banks’ debt during FY-05 and FY-06 [ the years of monetary tightening] which was inflationary as admitted in the SBP reports. The SBP report for H1-FY 07 indicates that this policy has undergone a shift and now the government is borrowing not only from the SBP but also from the commercial banks. This is a welcome change.

The SBP claims that the monetary tightening has resulted in softening the demand pressure which has helped in easing the inflationary pressures. This does not seem to be true. The private consumption expenditure (at Current Factor Cost) increased from 16.2 per cent in FY-04 to 22.6 per cent in FY-05 and to 22.3 per cent in FY-06 [SBP annual report for FY-06]. In the monetary tightening years demand pressures rather increased as compared to FY-04.

The overall inflation (CPI) decelerated from 9.3 per cent (FY-05) to 7.9 per cent (FY-06). The food inflation also came down from 12.5 per cent in FY-05 to 6.9 per cent in FY-06. But despite sizable reduction in M-2 as well as in credit expansion in FY 07, inflation is not receding. The CPI inflation (average) was 7.9 per cent at the close of FY-06 which at the end of February,2007 is 7.7 per cent: a very marginal change. The core inflation (non-food/non-oil) has decelerated to six per cent at the end of February,2007.

The people from the lower strata of the society are more affected by the food inflation which was (year-over-year) 10 per cent at end-Febryary,2007. Due to high rise in food prices, the food inflation which constituted 38.3 per cent of the CPI in Februaty,2006 has risen to 55.4 per cent of the CPI in February,2007[in November,2006, it was 53.1 per cent of the CPI]. The food inflation is likely to rise in the coming months due to increase in the prices of milk and edible oil.

The SBP report for H1- FY-07 asserts that the domestic prices of cooking oil and vegetable ghee remained quite stable until June,2006 despite significant decline in the international prices of soybean oil/palm oil. Here the question is why the prices did not decline as a corollary to the fall in the international prices of the edible oil, who was the beneficiary of the fall in the international prices and why were the administrative measures not taken to bring down the domestic prices?

What is the conclusion? Despite the monetary tightening, there was no desired reduction in the monetary/credit expansion in FY-06 while in FY-07 reduction in the private sector credit is visible but it is not solely due to tightened monetary policy but other factors are also involved. The deceleration in the inflation in FY-06 cannot be attributed to the tightening of the monetary policy because it is believed that the policy needs 12-18 months to show results. The tightening of the monetary policy does not affect food inflation.