WE have not been able to overcome inflation. It is high, generalised and well above the comfort level. This is a huge challenge unless we can learn to live with its stubborn double-digit face. This writer would argue that it is not possible to manage inflation through just one or two policy instruments.
The reason is that the sources of demand in the economy are households, the corporate sector and the government. These in turn are receiving money from different sources — both internal and external (earnings from economic activities carried out domestically or from exports or as remittances or investments from abroad or as in the case of government loans or grants from the international donor community).
The role of each source and what can be done about it is, therefore, somewhat limited, especially because the acts of one actor/agent can nullify the actions of the others, at times as a result of unanticipated developments.
For example, if those holding cash deposit it in the banking system it will, in the terminology of economists, increase the velocity of circulation of money and create price pressures.
Similarly, the increase in the rate of interest by the State Bank is supposed to change the behaviour of the borrower by reducing the demand for credit and thereby pruning the overall demand in the economy.
However, if that does not happen and the largest borrower — the government — continues to borrow and spend, as has been the case in Pakistan, it could completely negate the objective of the policy instrument of a higher interest rate.
Again, policy instruments to contain domestic demand can be rendered redundant by inflows of remittances or donor assistance which simply serve to create additional demand for domestic goods and services.
It is factors like this that make it difficult to handle inflation. This is also so because of the political economy complications of the effect of different instruments on the behaviour and earnings of these economic actors, some of whom have powerful lobbying capabilities or simply succeed in riding roughshod over any attempt to restrain them.
To illustrate this point further, it should be obvious that there are limitations of monetary policy instruments, like the interest rate, to fight seemingly unrelenting food inflation, the most pervasive aspect of our inflation, which touches the bulk, and especially the poorest households.
Food inflation has been inevitable as a result of several factors:
— Increase in wages beyond the improvement in national productivity (partly also the ripple effect of doubling of salaries of government employees in the last three years);
— The maintenance of the support/procurement price of wheat above international prices and imprudent piling up of large wheat stocks in government godowns;
— Increase in energy and oil prices pushing up costs of farming, processing and transportation;
— Hoarding and cartelisation; and
— Improvements in incomes and diversifications of diets of some segments of the population impacting prices from the demand side of high-value products like pulses, milk, livestock, vegetables and fruit against a weak supply response.
How does one deal with such inflation which is sticky and elevated? As has been argued before in these columns, addressing food inflation requires a comprehensive policy package comprising sensible fiscal and cash management, agricultural polices which incentivise increase in yields and cost efficiencies in production processes and an open trade policy to counter cartel formation, e.g. in sugar.
Inflation is caused by overall demand exceeding supply, although, admittedly, there may be supply shortfalls to meet increased demand even when there is excess capacity as a consequence of, say, lack of availability of energy.
Even if cost factors push up prices (reinforcing generalised inflation) there has to be adequate demand for all producers to be able to continuously pass on wholly or partially their increased costs to consumers.
Therefore, one way of addressing inflation could be to reduce present demand and shift it into the future, say through the increase in the tax rate on a temporary basis.
The other options could be sacrificing some growth for reining in inflation or accepting a higher rate of inflation to facilitate growth. The latter policy option would be selected in the hope that the supply effect of higher production may just ease the pressure on prices.
The other generally expected effect would be stimulation of demand, fuelling inflation, in an environment characterised by huge budget deficits resulting from unproductive spending on subsidies and bank-rolling of the losses of public-sector enterprises. In other words, any decision to either tackle inflation or kindle growth involves a trade-off.
Opting for one instead of the other would be easier said than done, especially if information on the economy is not adequate to assess the likely outcome of such a decision, in terms of the impact on the rate of inflation and the exchange rate of the rupee, if the central bank desiring to promote private-sector activity lowers the interest rate.
In the latter case, the State Bank could simply be trading for a higher rate of inflation for a somewhat modest increase in growth, especially if oil prices begin to firm up and the import bill rises in response to increased demand for cheaper credit and the war chest in the shape of the foreign exchange reserves is not big enough to defend the pressure on the rupee and prevent it from reaching the psychological barrier of Rs100 to a dollar.
We have to be mindful of all this if the government continues to borrow (irrespective of the price of the loans to finance its increased spending in an election year) from the banking system.
This would crowd out the private sector, particularly at a time when the growth in bank deposits would be expected to slow down in reaction to a reduction in the interest rate, with the related funds getting diverted to investments (including those of the speculative variety) that would generate higher returns than those earned from bank deposits.
The writer is a former governor of the State Bank of Pakistan.