THIS writer has argued before that it is not possible to manage inflation through just one or two policy instruments, especially when one instrument, the interest rate, is expected to achieve multiple objectives. The reason is that the sources of demand in the economy are households, the corporate sector and the government, which in turn receive money from different sources.

The role of each source and what can be done about it is somewhat limited, especially because the acts of one can nullify the actions of others, at times as a result of unanticipated developments. For example, when the State Bank of Pakistan increases the interest rate, it expects a change in the borrower’s behaviour. However, if the largest borrower, the government, continues borrowing to finance expenditures more than its revenues, it negates the objective of raising the interest rate.

Again, policy instruments to contain domestic demand can be rendered redundant by remittance inflows or donor assistance which create an additional demand for goods and services.

The effectiveness of State Bank policy to ‘target’ inflation is constrained by the structural nature of the problems. Monetary policy instruments have limitations. An increase in the interest rate cannot fight imported or food inflation when the latter is high because a) the wheat support price is above its international price; b) increases in energy and oil prices raise farming, processing and transportation costs; c) yields per acre of crops continue to be low; d) there is hoarding, and cartelisation.

Similarly, large areas of the economy suffer from rigidities in the prices administered by the government, poor governance adding to the costs; the tax structure is dependent on high rates of GST and other indirect taxes; and powerful cartels manipulate prices. These prices are not affected by weakening demand for goods and services and the government’s profligacy that keeps high budget deficits whose financing raises the interest rate on borrowings and crowds out the private sector seeking funds for investment.

It is such factors that make it difficult to handle inflation. For instance, addressing food inflation requires a comprehensive policy package comprising policies that incentivise increase in yields and cost efficiencies in production processes and an open trade policy to counter cartel formation — measures beyond the scope of monetary policy.

The stubbornness of a high inflation rate in a relatively depressed economy reflects the gap between the economy’s falling demand and supply capacities, the latter manifesting the rate of growth of the economy’s output. Such an outcome is only possible if productive capabilities are either not keeping pace with demand (reflected as higher imports) or have actually declined, a worrisome development and that too only partly because of lack of availability of energy at affordable prices. The latter is a particularly serious issue for small and medium enterprises.

This has happened because of weak private sector investment (although there’s some recent improvement mainly in sectors getting under-priced gas), despite the large-scale manufacturing sector having picked up the market share from SMEs that are winding up and made decent profits. Other key factors have been poor productivity (failure to get higher outputs from existing resources) and investment in unproductive projects or those that have stalled.

Furthermore, simply pursuing single-mindedly the goal of checking inflation can adversely impact growth and employment creation. The State Bank does not have an adequate set of policy instruments to stimulate growth, lower the rate of inflation and ensure stability of the currency exchange rate, all at the same time. Moreover, inflation targeting has not been adopted as the sole objective by all central banks. Economic power houses China and America appear as non-inflation targeting countries.

The monetary policy should focus only on tackling the domestic business cycle. In developing countries if growth has to be given an impetus it requires low interest rates. But a sharp decline in inflows of external capital may warrant high rates of interest to incentivize foreign inflows (as has been one of our arguments for jacking up interest rates) which, in turn, can worsen the adverse movement in the domestic business cycle.

The internal and external imbalances of advanced economies can be addressed simultaneously. They can afford the luxury of printing currencies, because the latter can be freely converted and traded in international financial markets, ie they can conduct their monetary policy freely to meet the requirements of the domestic business cycle.

Conversely, the currencies of developing countries are not freely convertible and tradable. These economies need capital inflows and donor support to maintain foreign exchange reserves in tradable currencies to enable them to face any crises in financing external obligations. In our case, external payment crises require bailouts by the IMF and other multilateral and bilateral donors and ‘special friends’ in the Middle East.

The Pakistani rupee is ‘free floating’ when it comes to trade in goods and services as well as the ‘capital account’ (especially in the case of non-residents). Any restriction on bringing in and repatriating foreign capital will make external investors reluctant to bring in this money. And reliance on large inflows of borrowed capital on a continuous basis is not sustainable. It enlarges these imbalances over time, creating conditions for external payment crises. The threat of such crises forces countries like Pakistan to opt for a monetary policy instrument, a higher interest rate, to tackle external crises — an intervention more likely to fail.

The writer is the Vice Chancellor of Beaconhouse National University.